International Tax Study Circle Meeting, ICAI, Bangalore Chapter, 25 March 2006 Agenda Tax Treaty Structure Article I of the OECD Model Convention Vishnu Bagri

Backdrop OECD Model Tax Convention (MTC) on Income and on Capital, 2005 OECD format primarily “resident based” taxation Treaty provides the rights of the Contracting States to tax a particular income stream Other models such as UN/US have a similar structure

A Cross Border Situation India Overseas Overseas Company Branch Indian Company Income Streams

Outline of a MTC ARTICLE NUMBER TITLETYPE OF PROVISION Chapter I : Scope of the Convention 1Persons CoveredScope 2Taxes CoveredScope Chapter II: Definitions 3General DefinitionsDefinition 4ResidentDefinition 5Permanent EstablishmentDefinition Chapter III: Taxation of Income 6Income from Immovable Property Substantive (asset) 7Business ProfitsSubstantive (activity)

Outline of a MTC ARTICLE NUMBER TITLETYPE OF PROVISION 8Shipping, Inland Waterways Transport and Air Transport Substantive (special) 9Associated EnterprisesAnti-avoidance 10DividendsSubstantive (asset) 11InterestSubstantive (asset) 12RoyaltiesSubstantive (asset) 13Capital GainsSubstantive (capital gain) 14Independent Personal Services [Deleted] Substantive (activity) 15Income from employmentSubstantive (activity) 16Directors’ FeesSubstantive (special) 17Artistes and SportsmenSubstantive (special)

Outline of a MTC ARTICLE NUMBER TITLETYPE OF PROVISION 18PensionsSubstantive (special) 19Government ServiceSubstantive (special) 20StudentsSubstantive (special) 21Other IncomeSubstantive [“Catch-All” Clause] Chapter IV: Taxation of Capital 22CapitalSubstantive Chapter V: Methods for Elimination of Double Taxation 23AExemption MethodElimination of double taxation 23BCredit MethodElimination of double taxation

Outline of a MTC ARTICLE NUMBER TITLETYPE OF PROVISION Chapter VI: Special Provisions 24Non-DiscriminationMiscellaneous 25Mutual Agreement ProcedureElimination of double taxation 26Exchange of InformationMiscellaneous 27Assistance in Collection of Taxes Miscellaneous and optional 28Members of Diplomatic Missions and Consular Ports Miscellaneous 29Territorial ExtensionMiscellaneous and scope Chapter VII: Final Provisions 30Entry into ForceScope 31TerminationScope

How does it operate? Step 1 -- determine if the issue is within the scope of the convention: Determine whether the tax payer is within the personal scope i.e. persons who are residents of one or both ‘contracting states’ Determine that the treaty applies to the tax issue - is it a tax listed in Article 2 Determine that the treaty is in operation (entry into force and termination) Determine if the treaty has been given effect in the domestic laws of the concerned state Step 2 -- Apply the relevant definitions Residency test Permanent Establishment

How does it operate? Step 3 -- Determine which of the substantive provisions or distributive rule apply Distributive rules organized according to types of income (Ch III) or capital (Ch IV)  Arrangement has been established by tradition  Typically income from (i) certain activities, (ii) certain assets, (iii) capital gains and (iv) residuary rule  Other rules are special rules (shipping in relation to business profits) and (artisans and sportsmen in relation to independent and dependent personal services) Types of income designated by treaties, therefore, should by no means be confused with those of domestic law, even where they do exist in the domestic law, any resemblance that may show up will be superficial and accidental  Example FTS classification,

How does it operate? Step 3 -- Determine which of the substantive provisions or distributive rule apply (contd) Process of characterization important to determine rights of the respective Contracting States  Distributive rules with Complete legal consequences (“shall be taxed only in”) to be distinguished from incomplete or open legal consequences (may be taxed in..)  If a given income stream meets requirement of more than one DR, those referring to income from assets take priority over those governing income from activities. Exception is if income from asset held by a PE then Article 7 would apply. Assistance in characterization can be gained from commentaries to the model conventions, case laws, etc

How does it operate? Step 4 -- Apply the substantive article. These generally take 3 forms: State of source may tax without limitation - e.g. business profits of a PE State of source may tax upto a maximum - e.g. royalties State of source may not tax - e.g. business profits where there is no PE Step 5 -- Apply the provisions for elimination of double taxation i.e. credit method or exemption method Step 6 -- Follow the treaty provisions into the domestic law i.e. apply the mechanism for obtaining tax credit and if domestic law application does not give the treaty entitlement, MAP could be considered Above is only a simplistic and indicative approach. More detailed application required but helps to understand using above steps.

Article I The Convention shall apply to persons who are residents of one or both of the Contracting States Persons (Art 3) and residents (Art 4) defined A permanent establishment is not a person and so not entitled to treaty benefits. An important principle especially in triangular cases It is the owner of the PE which can qualify for treaty protection if it is a resident of a contracting state

Article I OECD has adopted residence as the basis for the scope of the Convention, US explicitly reserves the right to tax its citizens without regard to any DTC Commentary also covers to more general points not covered elsewhere in the Model which fall loosely under the heading of ‘personal scope’ Application of convention to a partnership Improper use of the Convention or treaty shopping

Application to a Partnership MC does not contain any specific provisions given the diversity amongst member states on the taxation principles for a partnership Some countries treaty partnerships as a “transparent” entity and some “intransparent” Tax treatment of various heads of partnership income and capital employed also differ among jurisdictions Partnerships raise a number of issues with respect to the application of DTC. There is a report by the Committee to Fiscal Affairs entitled “The Application of the OECD Model Tax Convention to Partnerships”

Application to a Partnership Is partnership a “person”? Yes, e.g. body of individuals Does the partnership qualify as a “resident” of a contracting state? Difficult to determine, specially in cases where it is considered as a fiscally transparent entity Characterization of income derived by a partnership or its partners The complex situations could be grouped as follows: The organization as such may be deemed liable to tax (intransparent) in both contracting states The entity is treated as intransparent in one state and transparent in the other state Organization is transparent in both contracting states

Improper Use of Convention Whether the DTC benefits must be granted when transactions constitute an abuse of the provisions? Generally dependent upon domestic law, unless specific provisions provided in treaty Whether specific anti-abuse provisions/jurisprudential rules of the domestic law conflict with tax Conventions? As a general rule, there will be no conflict between such rules and the provisions of the DTC Some jurisdictions prefer to view some abuses as treaty abuse as opposed to domestic law abuse. However, even treaty abuse not acceptable since it is unintended

Improper Use of Convention Adopts the OECD report and suggested benchmarks for solutions to treaty abuse Solutions currently dealt within the Convention Art 1 & 4 (Person & residence) Beneficial Owner (Art 10, 11 & 12) Other Solutions suggested by the Commentary Direct Conduit cases – use of “look-through” approach Preferential tax regime – use of “exclusion” approach or “subject-to-tax” approach Stepping stone cases – use of “channel” approach

Improper Use of Convention Recommends use of accompanying provisions to protect “bonafide” cases Bonafide provisions to avoid “over-reaction” of the anti-abuse law General Bonafide provision (establishment of business purpose) Activity provision (substantive business operations & active income) Amount of tax provision (residence state tax exceeds source tax) Stock exchange provision (listed companies and their subsidiaries) Alternative relief provision (comparable tax relief by non-residents) The domestic measures should comply with the spirit of tax treaties

Improper Use of Convention Additional Comments: Additional Solutions Place of effective management Criterion Anti-abuse provisions against creation or assignment of passive income- rights Insertion of provisions through exchange of notes after signature of the Convention Limitation of benefits (LOB) Provisions Comprehensive provision to tackle treaty shopping Choice left to the treaty negotiators to insert this solution India judicial decisions: to have business or commercial purpose (in addition to treaty benefits)

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