International Taxation

Some Important Terms – Concepts
 

In this article we shall familiarize with some important terms used in the Model Convention (DTAA) – namely, Persons covered (Article 1), Taxes covered (Article – 2) and General Definitions (Article 3). We shall also inter alia cover some concepts in International Taxation and Article 29 and Article 30.

1. Article 1 – Persons covered

Article 1 seeks to specify who are covered by the Model Convention (MC), Article 1 of the OECD MC states that the Convention shall apply to persons who are residents of one or both the Contracting States.

1.1 The term ‘person’ is defined in Article 3(1) (a) of the MC whereas the term ‘resident’ is defined in Article 4 of the MC.

1.2 The wording in Article 1 in the OECD and the UN MCs are identical.

1.3 The Article 1 of the US MC has additional provision. It provides that irrespective of the residential status of person (as determined under Article 4), a Contracting State would have the right to tax its citizens or even in certain cases, former citizens who have given up their citizenship with the principal objective of avoidance of tax. This provision seeks to ensure that there is no Treaty abuse by relinquishing the citizenship in order to avoid payment of taxes.

1.4 Permanent Establishment and treaty protection

The term ‘permanent establishment’ is defined in Article 5 of the MC. A permanent establishment does not have a legal identity separate from or distinct from its head office. The owner of a permanent establishment qualifies for treaty protection only if he himself is a resident of a country. Accordingly, a 'permanent establishment’ is covered by the definition of ‘person’ and hence PE would not be entitled to treaty protection.

1.5 ‘Transparent’ and ‘intransparent’ entity

1.5.1 Transparent entities

Entities which are not subject to tax at the entity level; i.e., subject to tax independently, rather, where partners or certain beneficiaries are treated as the tax subjects directly, may be referred to as ‘transparent entity’.

1.5.2 A legal entity, which itself is subject to taxation may be referred to as ‘intransparent’ entity.

1.6 ‘Abuse of double tax convention’ (Treaty’)

1.6.1 The main purpose of a treaty is to promote exchange of goods and services, and the movement of capital and people between the residents of two countries, by eliminating double taxation. Sometimes, provision of treaty may result in tax avoidance in both countries or reduction in tax rates beyond that which is contemplated by both the countries.

1.6.2 A tax-payer may try to escape incidence of tax liability by improperly using misusing the provisions of a treaty. For example, interposing a company in a country in order to take treaty benefits which otherwise would not be available. Such improper use of a treaty is commonly referred to as abuse of a treaty.

Some tax treaties (DTAAs) specifically prohibit the abuse of Tax Treaty. (Eg. US)

1.7 Tools generally used for tax avoidance under international laws

1.7.1 Treaty Shopping: Treaties are used for tax planning purpose. More precisely, it is the legal opportunities very often that arise from tax treaties which are so used. Numerous transactions are aimed at obtaining the benefits of a treaty which would not otherwise be available to the tax-payer as he is not resident of a country. Country ‘A’ may not have Treaty with country. But country ‘C’ has Treaty with country ‘B’. In order to obtain Treaty Benefits with ‘B’ a company in country ‘A’ may incorporate a subsidiary in country ‘C’. Subsidiary can access Treaty with country ‘B’. These arrangements are known as ‘treaty shopping’.

1.7.2 Rule Shopping

Another tool used for tax planning is by making certain distributive rules of the treaty applicable. For instance, dividend is engineered as interest in such a way that countries to the treaty do not leave withholding tax on dividend as well as interest. Such types of arrangements are referred to as ‘Rule Shopping’.

1.7.3 Anti ‘Treaty Shopping’ and ‘Rule Shopping’ Provisions

Special provisions have been developed to combat avoidance of tax through circumvention of treaty. Several treaties today contains ‘subject-to-tax’ or ‘activity’ and ‘productivity’ clauses with an intention to eliminate the loop holes for abuse of the treaties.

1.8 Reports published by OECD commentaries specifically dealing with treaty abuse

1.8.1 OECD has published two reports on this issue titled ‘Double taxation conventions and use of base companies’ and ‘double taxation conventions and the use of conduit companies’. Further extensive use of commentaries have been published on this issue in the OECD Model Convention. One may usefully refer to them for detailed information.

1.8.2 It is pertinent to note that if a treaty does not contain any ‘anti-abuse’ provision, specifically then the same should not be read into the Treaty. The wordings of the treaty have to be respected and if it does not contain an anti-abuse clause, then normally the same should not be presumed to exist (refer to the decision of the Supreme Court of India in the case of Union of India, et al vs. Azadi Bachhoo Andolan, et al (263 ITR 706).

2. Article 2 – Taxes covered

2.1 The scope of Article 2 – Taxes covered under the MC

The MC encompasses only such taxes as are based on, or derived from governmental fiscal sovereignty (payments which generate revenue). Article 2 of the treaty applies to taxes on income and capital. It comprises taxes assessed directly and also taxes which are withheld at their ‘source’. Further taxes calculated as supplementary levies or surtaxes are also covered.

2.1.2 The wording contained in Article 2 in the OECD and the UN MCs are identical.

2.2 Additional provision in the US MC

The OECD and the MCs seek to cover the same kind of taxes. However, while the OECD MC has general provision stating that all taxes on income and capital imposed in a Contracting state would be covered. However, the US MC specifically mentions the taxes (eg the income taxes imposed under the Internal Revenue Code) that would be covered by the Convention.

2.3 The nature of ‘taxes’

The word taxes’ is not defined in the MC and therefore recourse must be had to the meaning assigned to it under the domestic law of the country.

2.3.1 Taxes on income and capital include taxes on total income and on elements of income such as salaries and wages; taxes on total capital and on elements of capital such as gains from alienation of property and appreciation of capital.

2.4 Taxes generally not covered by treaties.

2.4.1 The treaties do not cover all non-governmental taxes, dues, duties etc.. Further, indirect taxes such as excise duty, sales tax, VAT etc. are not covered by the treaties. Also, social security charges, monetary fines and penalties, interest for late payment of taxes etc. are not be regarded as ‘taxes’ as such payments are not designed to produce revenue.

2.4.2 Taxes specified by a treaty

The word ‘taxes’ is not defined in the MC and hence MC does not specify the list of taxes covered. However, as treaty normally contains a list of domestic taxes that are in force in both the countries at the time of signing the treaty. If a tax existed at the time of signing the treaty but was not mentioned in the list of taxes in the treaty, the treaty will not cover the same.

2.5 Position of taxes which are imposed after the date of signature of TREATY

2.5.1 Since the list of taxes covered is purely declaratory in nature, every treaty would also contain provision stating that any new taxes imposed, which are identical or substantially similar in nature, in place of or in addition to the listed taxes, the same would be automatically covered by the treaty.

2.5.2 In other words, in order to guarantee comprehensive treaty benefits, (not to dilute the benefits of treaty) treaties normally extend their scope to cover identical or substantially similar taxes which are imposed after the treaty has been signed, in addition to, or in place of the existing ones. The extension of the treaty field of application to include similar taxes ensures that changes in tax laws will not result in a treaty becoming inoperative or less beneficial.

2.6 Intimation of changes in Tax laws to treaty partners

Treaties normally contain a rule stating that at end of each year, the competent authorities of the countries to the treaty shall notify each other of any significant changes in their taxation laws.

2.6.1 Consequences if changes are not
intimated

If a country fails to notify any such changes in its tax laws to the Treaty Partner, the new taxes would still come under the purview of the treaty. The country which failed to make such notification cannot be denied the right to apply its changed domestic law. This is true not only with regard to express changes in the domestic laws but particularly also cover cases affected by the rulings by the authorities or case law, on the interpretation of a law in substantive aspects.

3. Article 3 – General definitions

3.1 The wording in Article 3 both in the OECD and the UN MCs are identical.

3.2 The definition of ‘person’

The term ‘person’ is defined under Article 3(1)(a) of the MC. The definition is not exhaustive and is an inclusive definition. The definition explicitly includes individuals, companies and any other body of persons.

3.3 Treaty protection to ‘person’

Domestic laws of the country applying the treaty determine the point of time from which an individual will start enjoying the treaty protection. For example, under German tax laws a child will have legal capacity upon birth whereas under French tax laws a new born child obtains legal capacity if it is viable.

3.4 Coverage under definition of ‘company’

Under Article 3(1)(b) of the MC, the term ‘company’ means any body corporate or any entity that is treated as a body corporate for tax purposes. The term company is used in various special rules particularly where the profits of, interest in and distributed by, companies are involved. Body corporates are entities to which the legal systems attribute legal capacity to the same extent as it does to individuals, except for the legal relationships that are from their very nature restricted to individuals.

3.4.1 Any body corporate created under the law of any country is a ‘company’ and consequently a ‘person’ under the MC. Similarly political sub-division and local authorities are considered as ‘body corporate’ and therefore ‘persons’.

3.4.2 Practical issues in the applicability of a treaty arise when an entity in a treaty as a transparent entity for tax purposes but a body corporate for corporate purposes (eg. Limited Liability Companies in the US). LLCs are not taxed but their member are directly taxed.

3.5 Meaning of Treaty protection available to an enterprise

3.5.1 Under Article 3(1)(c) the terms ‘enterprise of a country’ and ‘enterprise of the other country’ are defined to mean an enterprises carried on by a resident of a country and by a resident of the other country. (Treaty Partner)

3.5.2 An enterprise carrying on business in a country does not enjoy treaty protection if the person carrying on the enterprises is resident of any other country. Treaty protection depends upon the residence of the persons carrying on the enterprises rather than the place from which the enterprise is carried on.

3.5.3 The decisive point is who carries on the enterprise. The MC looks at the person who actually exercises the power to make decision.

3.6 Meaning of ‘international traffic’ under a MC

The term ‘international traffic’ has been defined under Article 3(1)(d) of the MC. It means any transportation by a ship or aircraft operated by an enterprise that has its place of effective management in a country, except when the ship or aircraft is operated solely between places within the other country. The definition is broader than the term normally signifies. The definition is primarily important in connection with taxation in respect of profits made by the enterprises engaged in shipping and aircraft business.

3.7 The ‘competent authorities’ under treaty

This is an enabling definition in execution of the Treaty by delegated authority. Execution of Treaty is not left to the competence of the highest tax authorities, but is delegated for easy implementation. The definition enables each country to a treaty to nominate one or more authorities as being competent to execute the treaty. In India, the competent authority is the Ministry of Finance (Department of Revenue) or their authorized representatives.

3.8 The term ‘national’ and its coverage

Under Article 3(1)(f) of the MC, the term ‘national’ would cover.

1. any individual possessing the nationality of a country.

2. any legal person, partnership or association deriving its status as such from the laws in force in a country. The nationalities for non-individuals depend on the law from which they derive their status.

3.9 Terms not defined in a treaty – Rule of interpretation

3.9.1 Article 3(2) of the MC provides for general rule of interpretation in respect of terms used in the conventions but not defined therein. However, the question arises as to which legislation must be referred to in order to determine the meaning of terms not defined in convention; i.e., whether the legislation in force when the convention was signed or that in force when the convention is being applied; i.e., when the tax is imposed. The latter situation would prevail, unless the context in which the interpretation is being made requires otherwise.

3.9.2 Further, where the terms are used in the treaty but not defined therein, such terms will be interpreted in accordance with the domestic law of each country. Such express reference to domestic law has certain advantages such as easy reference and reliance by tax-payers, tax authorities courts and legal fraternity However, there may be some negative consequence such as both the countries to treaty may attach different meaning to the terms for applying provisions of treaty which may unwittingly result into double taxation or double non-taxation.

4. Article 29 – Entry into force

4.1 Date of ‘entry into force’ of a treaty

The date of entry into force of a treaty is the date from which various provisions of the convention are applicable in each country to the convention. Generally a treaty enters into force on the date specified therein. However, where no date is specified, it will enter into force upon the exchange of instrument of ratification. The importance of date of entry into force is that on and from that date the two countries are bound by international law to apply the provision of the treaty.

4.2 The procedure for treaty to come into force

The steps for a treaty come into force can be divided into following stages.

1. Negotiation and signing of the draft treaty. This is followed by the following further steps.

2. Ratification of the treaty by the concerned authority.

3. Handing over of the ratified documents/exchange of notes indicating the completion of the process of ratification.

4. Entry into force.

5. Effective date.

4.3 Meaning of the term “ratification of treaty”

4.3.1 Ratification of the treaty is one of the ways of approving or granting consent to a bilateral or Multilateral Agreement by a responsible body of the country concerned. Many times the representatives of both the countries may initial the treaty documents after successful completion of negotiation between them. But until the time the treaty documents is ratified, it will remain a mere draft, which can be altered, amended or modified by the body responsible for ratification.

4.3.2 Thus initializing of the documents only indicates the commitment of the two countries to initiate further procedure as required under its constitutional and the domestic law. The Treaty documents become final and conclusive only after each country ratifies it.

4.4 Ratification and Parliamentary approval

Ratification of treaty documents should be distinguished from Parliamentary approval of treaty. Parliamentary approval is necessary in most of the non-commonwealth countries. Unless specifically required by the constitution of the country, ratification is generally approved by the responsible body, or competent authority in a country. From Indian context, since under section 90 of the Income-tax Act, 1961 the Indian Parliament has given the Central Government the right to enter into treaties, no Parliament approval is required in India for ratifying a treaty. Section 90 is the empowering section.

4.5 The ‘effective date’ of treaty

It is the most important date on which the provision of the treaty becomes effective in each country. It is the date when the provision of a treaty will be actually start to apply to situation arising on or after the date.

4.6 Generally the effective date will be decided on the basis of domestic law of the country concerned and may be different for both the countries. For example India’s financial year commences on April 1st and ends on March 31st next following, while the USA follows the calendar year; i.e., Jan. to Dec., as its financial year.

4.7 From the effective date the obligation of the person qualifying for treaty protection would be in accordance with the provision of the distributive rule of governing of respective income and capital unless the domestic law of the source country overrides the treaty.

4.8 The ‘date of entry into force’ and the ‘effective date’ – Subtle difference

The date when the treaty enters into force may or may not be same as date when the provision of treaty become effective; i.e., effective date.

4.9 Sometimes, the effective date of the treaty may precede the date on which treaty enters into force. In such a case the provision of treaty will have retrospective effect; i.e., they would have effect in respect of past transaction also. For example India’s treaty with Saudi Arabia and Cyprus provide for with retrospective effect.

4.10 Further, all provisions of a treaty may not necessarily be effective from the same day. A treaty may provide for different effective dates for different provisions. For example some provisions may have retrospective effect while other provisions may apply from the effective date whereas some others may be effective from the future date or on happening of some expected event in future.

5. Article 30 – Termination

5.1 The date of termination of treaty

The date of termination of treaty is the date from which various provisions of the treaty will cease to be applicable in each country.

5.2 Procedure for termination of treaty between two countries

Treaty being an international obligation cannot be terminated abruptly.

Termination of treaty is normally unilateral act; i.e., the country desirous of the ending the treaty has to give a notice of its intention to terminate the treaty to the other country in terms of the treaty. The notice is required to be given through Diplomatic channels.

5.3 Upon receipt of Notice of termination, the treaty will cease to have effect in the two countries from the effective dates mentioned therein. Treaty comes to an end after the notice period expires.

5.4 Notice of termination can be given at any time after the treaty has been entered into

The UN model does not mention any specific period after which notice of termination is to be given and leaves it open to the treaty partners to provide for same. In case of India, most of the treaties entered into with other countries provide that the notice of termination can be given only after expiration of five years from the date of entry into force of the treaty. India treats ‘treaties’ as long-term international commitments.

5.5 The effective date of termination of treaty

Just like date of entry into force of treaty, date on which a treaty ceases to have effect may also be different for both the countries. This date generally coincide with the date beginning of the new financial year of the respective country.

5.6 The object of ‘termination clause’

5.6.1 The tax laws or the economic situation and political conditions/situation of any of the contracting states may change. As a result the purpose for which the treaty was entered into may become redundant. This may result in treaty ceasing to provide a reasonable balance it was indented to provide. In such an event the country may decide to terminate the treaty.

5.6.2 The purpose of termination clause is to make it possible for the two countries to disengage in an orderly manner from their commitments under the treaty. It is an honourable exit route.

5.7 The effect of termination of treaty

5.7.1 The termination is a unilateral declaration whereby a country gives notice to the treaty partner to terminate its relationship with effect from specific date and in accordance with the provision of the treaty. The provision of the treaty will cease to have effect from such specified date.

5.7.2 Once the treaty is terminated, all the restrictions on provisions under domestic laws as well as special benefits available under the treaty will cease to have effect. Accordingly, any taxable event occurring after the effective date of termination will be governed exclusively by the provision of the domestic law of the country concerned. This may
result into double taxation of incomes or capital.

5.7.3 Termination is an extreme step and many times two countries prefer to modify certain provision of a treaty or to renegotiate the treaty with mutual consent. It is only when such negotiation fail, country may opt for termination of treaty. Till date, India has terminated comprehensive treaty only with Pakistan and has in its place negotiated limited treaty .

5.8 Position of ‘notice of termination’ withdrawn.

5.8.1 Unlike termination, withdrawal of notice of termination requires consent of the other country, which the other country may or may not give. It is doubtful whether notice of termination once given may be withdrawn unilaterally. It is also doubtful whether a notice of termination once given can be modified to a limited extent; i.e., to convert comprehensive treaty into a limited treaty dealing with certain incomes or capitals only.

5.8.2 If however the other country agrees to a withdrawal or modification, this may be considered to constitute the treaty afresh, admissibility of which under the domestic law will, however depend on the relevant constitutional provisions.

6. Protocol

‘Protocol’ is used to modify certain provisions in the Treaty to remove irritants and make treaty workable.

These terms are important while reading a Treaty.