3.3.2.2 Art. 1, 3 and 4 OECD MTC: Persons covered, General definitions and Resident

Introduction

Art. 1 OECD MTC defines the personal scope of the Convention. As discussed above, an OECD compliant Convention applies to persons who are residents of one or both of the two Contracting States.1 Understanding the scope of application of tax treaties thus requires, first of all, a consideration of the concepts of person and resident in general.

Person

The first requirement for being able to rely on a tax treaty is that the taxpayer must be a person. A person includes an ‘individual, a company and any other body of persons.’2 A company is subsequently defined as ‘any body corporate or any entity that is treated as a body corporate for tax purposes’.3 A body corporate is an incorporated entity that has legal capacity for tax purposes. The entity should be subject to corporate income tax. This tax should be levied separately from its shareholders/partners/members.4 Tax groups do not fall within the scope of the definition of person for tax treaty purposes, but their members may.5Thus, the definition of company in principle does not include group companies and thus expresses the separate entity approach.6

The OECD MTC also defines the term enterprise. The use of the word enterprise may raise the question of whether the OECD is pursuing a variant of a group approach with this term. The term enterprise is defined as ‘the carrying on of any business’.7 This term refers to the enterprise activities as such, rather than to the person. It does not seem to be applied as a variant of a group approach. The definition does not indicate a link with a multinational enterprise.8 In line with art. 1 OECD MTC, a treaty only applies to a person who is a resident of one or both of the Contracting States. Treaty protection for an enterprise therefore depends on the domicile for treaty purposes of the person carrying on the enterprise.9

Residence – art. 4, par. 1, first sentence, OECD MTC

If there is a person who may be entitled to treaty benefits, the second step is to verify whether this person can be considered a treaty resident.10 Art. 4 OECD MTC defines the concept of resident.11 Natural persons and entities12 will be considered to be treaty residents if, under the national legislation of one of the Contracting States, they are subject to full taxation by reason of domicile, residence, place of management or any other criterion of a similar nature.13 If a natural person or entity is liable to tax only on certain sources from a state or on capital situated in that state, it is not a treaty resident.14

Art. 4, par. 1, first sentence, OECD MTC stipulates that in order to qualify as a treaty resident a person must be liable to tax under national tax laws.15 The person must therefore have unlimited subjective tax liability. Even if a person is deemed to be a resident of a state on the basis of a fiction, there may be liability to taxation.16 The term liable to tax therefore refers to a formal tax liability.17 The liability to tax requirement ensures that a person has a certain economic link with a state. Wheeler rightly raises the question of why the existence of such an economic link is not tested.18 Moreover, the application of the concept of liable to tax leads to ambiguities: it is not always clear when a person is no longer considered liable to comprehensive taxation and thus no longer is a treaty resident.19

A problem with following national liability to tax is the fact that many countries apply formal criteria to impose liability to tax.20 If there is a legal entity which has been incorporated under the law of a certain state, in most countries an immediate domestic tax liability on its worldwide income arises, regardless of whether activities are carried out in the relevant state.21 This procedural approach provides opportunities for treaty shopping and therefore does not match with the objectives of the OECD MTC.22 An advantage of the formal approach is that it provides legal certainty. In my view, making sure there are no opportunities for tax avoidance should in this regard be of more importance than legal certainty, as the former is one of the main objectives of the OECD MTC.

A second problem of following liability to tax under national law arises in relation to exempt entities.23 The fact that exempt entities are able to claim treaty benefits creates opportunities for double non-taxation.24 For example, Contracting States generally consider a pension fund to be a resident, regardless of whether the pension fund is wholly or partially exempt from taxation.25 For the purposes of the OECD MTC, treaty residence would seem to exist if a country in principle taxes an entity but then exempts all income or taxes it at 0%. This, however, is not the case if there is no initial liability to tax. It seems irrelevant that the situation is substantively the same.

A third point of attention is the question to which type of tax an entity should be liable.26 The first sentence of art. 4, par. 1, OECD MTC does not contain any requirement as to the type of tax. In that context, it could be claimed that any form of taxation would be sufficient to conclude that the entity is liable to tax.27 From the second sentence it seems that, for the first sentence too, it must be about a tax on income. However, case law shows that this element can be a point of discussion, and that a type of tax other than a tax on income may be sufficient.28 The reason for ‘accepting’ such a different type of tax seems to be that the tax liability must be assessed for each type of tax. Liability to a certain type of tax may then be sufficient to qualify as a treaty resident.29

Residence – art. 4, par. 1, second sentence, OECD MTC

The second sentence of art. 4, par. 1, OECD MTC limits the scope of application of the treaty residence provision as described above. The sentence stipulates that the term resident of a Contracting State does not include any person who is liable to tax in that state in respect only of income from sources in that state or capital situated therein. Mere source taxation is thus not sufficient to conclude that a person is a resident.30This situation applies, inter alia, to dual residents: entities that are residents of two Contracting States under national law. An entity incorporated under the law of state A and effectively managed in state B could in principle avail itself of two groups of tax treaties: the tax treaties concluded by state A with third states and the tax treaties concluded by state B with third states. The entity could thus still rely on tax treaties concluded by the ‘loser state’ with third states. The loser state is the state in which the entity is not considered a resident under the treaty between state A and B. If the entity in the loser state can still claim the benefits of both countries, a situation may arise – for instance, in the case of a dual resident parent company receiving dividends – where the source state must grant treaty benefits under two treaties. The taxing rights of the source state are then limited to the most restrictive agreed withholding tax rate.

In 2008, it was added to the OECD Commentary that in the case of dual residents, from the perspective of the objective of art. 4, par. 1, second sentence, OECD MTC, it must be concluded that no liability can be derived from tax treaties concluded by the loser state.31 The reason for this is that it cannot be said that there is a comprehensive tax liability in the loser state. As a result, art. 4, par. 1, second sentence, OECD MTC functions as an anti-abuse provision. This addition to the Commentary gave rise to criticism in the literature.32 After all, the addition in the Commentary does not seem to be in line with the wording of the second sentence of art. 4, par. 1, OECD MTC, which reads as follows:

An entity that is a dual resident may have a permanent establishment in the loser state because of activities conducted in that state. In that case, the income of that permanent establishment will be taxable in that state. The same will apply to any income of the permanent establishment from a third state, resulting in taxability of income from a third state.33 In such a case, the requirement of the sentence quoted above is not met.34 The exclusion of treaty residence which – according to the OECD – the second sentence of art. 4, par. 1, OECD MTC tries to effectuate for the loser state for treaties with other countries, does not seem to be in line with the text of the provision.

The OECD’s position can also be criticised if the first sentence of art. 4, par. 1, OECD MTC is considered. After all, it is necessary to refer to national tax law in order to determine whether liability to tax exists. From this background, it is not logical to apply a different test for the second sentence and to take into account the application of a tax treaty.35 The view as included in the OECD Commentary therefore does not seem to be consistent with the text of the provision.

It can also be argued that there may be overkill for the loser state, if there is a substantial presence there.36 With such a substantial presence, it could be argued that there is a sufficient connection with the loser state to be able to claim treaty benefits. Gooijer rightly states that this outcome is a consequence of the choice that was made to only grant treaty benefits to treaty residents, and not of an incorrect interpretation of art. 4, par. 1, second sentence, OECD MTC.37

However, it can be argued that not granting treaty benefits under treaties between the loser state and third countries fits the purpose of the provision. The background of this provision is precisely to ensure that only persons who are partially or fully subject to tax in one of the Contracting States can claim treaty benefits.38 Furthermore, it can be stated that the test of art. 4, par. 1, OECD MTC is a substantive test, so that the reason for the restriction of the liability to tax – whether because of national law, tax treaties or some other reason – is not relevant.39 This will prevent treaty benefits from being granted in inappropriate circumstances, which fits within the objectives of the OECD MTC.

Although the arguments described above are valid to state that the interpretation favoured by the OECD with regard to dual residents encounters textual objections, it would seem that importance should particularly be attached to the objective of art. 4 OECD MTC in the tax treaty. From that perspective, denial of treaty benefits to the loser state would be a logical outcome.

According to the OECD Commentary, the second sentence of art. 4, par. 1, OECD MTC also limits treaty application for conduit companies under certain circumstances. This is the case if the entity is exempted from taxation through privileges tailored to attract conduit companies.40 This OECD interpretation has been commented on in the literature, as it creates an inexplicable distinction between regular exempt entities (treaty residents) and exempt conduit companies (non-treaty residents).41

Residence and group companies

Treaty residence is keywithin the context of treaty shopping:42by being a treaty resident, treaty benefits can be claimed. The question arises whether group companies have or should have influence on whether or not entities are treaty residents. For group companies – just as for entities that are not part of a group – the starting point is the relevant law of incorporation. Any activities performed outside the state of incorporation may subsequently lead to a dual residence situation. Taking the state of incorporation as a basis may give rise to treaty shopping.43 As each group member is taxed separately, this provides treaty shopping opportunities.44 Hence, the starting point is at odds with one of the objectives of the OECD MTC, i.e., to prevent tax avoidance. This would require a change in the interpretation of the concept of treaty resident as such.45

The OECD Commentary discusses group relations that may be relevant to treaty application. This part of the Commentary is intended to provide guidance to Contracting States in situations where there is a potential for tax avoidance, while the Convention does not contain46 an applicable anti-abuse provision.47 The Commentary states that if a company is part of a group, this may affect its residence status under national law48 and, with that, the residence for treaty purposes.49 If treaty benefits are claimed by a subsidiary, for instance by an entity resident in a tax haven, it may be concluded – after considering the facts and circumstances of the case – that treaty benefits should be denied. After all, if this further examination shows that the place of effective management of the subsidiary is not in the alleged country of establishment, but in the country of establishment of the parent company, the group situation is relevant for determining the residence status. In the situation described above, the subsidiary in the tax haven could in fact be considered to be resident in the country where the parent company is established. This part of the Commentary therefore indicates that being part of a group can affect the application of national law and thus an entity’s treaty residence.50 However, it should be kept in mind that if a company is part of a group of companies, this does not necessarily imply that the effective management of the company is performed by the parent of the group.51

The Commentary on art. 1 OECD MTC further suggests that facts and circumstances of a situation may lead to the conclusion that an entity has a permanent establishment in the state where its parent company is located.52 Such a situation may arise where the place of management of the subsidiary is in the country of the parent company. This example is also included in the section of the Commentary dealing with methods of addressing tax avoidance through tax treaties. In brief, the Commentary indicates that in group situations, there could be a permanent establishment of the subsidiaries in the country of the parent company.53 Such a point of view seems particularly interesting for countries where no CFC legislation is in place.54

In short, according to the OECD a variant of a group approach should be applied to determine the residence of group companies, as all facts and circumstances should be taken into account. Specifically, to prevent treaty shopping the group situation of an entity may be relevant. This approach contributes to achieving the OECD MTC objectives.

Tiebreaker for dual residents

Art. 4 OECD MTC contains rules to prevent dual residence for treaty purposes.55 After all, legal entities56 can be residents of two different states. This may be the case, for instance, if one state applies the incorporation doctrine, while another state looks at the place of effective management of the legal entity. Art. 4, par. 3, OECD MTC contains a tiebreaker provision in this context. The OECD MTC prescribes a MAP to solve situations of dual residence of legal entities. For this MAP various elements have to be taken into account. These include where the board of directors' meetings are usually held, where the chief executive officer and other senior executives usually work and where the senior day-to-day management of the company is carried out.57 Pending the outcome of such procedures, a legal entity with dual residence is in principle not entitled to treaty benefits.58 If the MAP does not result in a solution, double taxation may occur.59

Under the pre-2017 version of art. 4, par. 3, OECD MTC, the place of effective management was decisive for determining treaty residence. Following the place of effective management – like following the place of establishment – creates opportunities for tax avoidance. For example, it is possible to hire external directors who ensure that the right decisions are taken at the right time in the right place.60 The current tiebreaker provision is aimed at preventing abuse due to the existence of opportunities for tax avoidance through the use of dual residents.61 The OECD Commentary and the report on BEPS Action 6 do not elaborate on which situations the OECD is referring to. It is assumed that dual resident situations are mainly the result of deliberate tax avoidance arrangements,62and it seems to be ignored that this can also be an unintended outcome.63 The adjusted tiebreaker still focuses on the place of establishment and the place of effective management, which does not solve the problem.64

In order to assess whether the tiebreaker should take better account of a company’s group situation, the OECD Business Profits Technical Advisory Group examined various scenarios in which parent companies had – partial – control over the board of directors of a subsidiary. Such control could be exercised, for instance, by appointing the directors or by having the directors only approve decisions taken by the parent company. The OECD Business Profits Technical Advisory Group published recommendations to change the OECD MTC in 2003. It recommended, inter alia, to add the following paragraph to the OECD Commentary on art. 4, par. 3, OECD MTC:65

The recommendations from the 2003 report of the OECD Business Profits Technical Advisory Group have not led to any changes to the OECD Commentary. The question is to what extent this ‘new’ approach would actually create a difference. Also in non-group situations, importance is attached to an entity’s place of effective management as part of the assessment on applying the tiebreaker in art. 4, par. 3, OECD MTC. If this effective management is exercised by a group company in another country, the effective management of the entity will be situated in that other country. In other words, if all facts and circumstances of the case are actually looked at to determine whether a company is resident, that company’s group situation seems to be automatically taken into account when applying the tiebreaker. This more explicit variant of a group approach advocated by the OECD thus seems to add little here.

All in all, the corporate tiebreaker as included in the OECD MTC seems to apply a substantive group approach as all facts and circumstances should be taken into account. This approach positively contributes to achieving the OECD MTC objectives as it aims to prevent tax avoidance.

Partnerships

Art. 1 OECD MTC includes a provision that refers to hybrid entities.66 Differences in the classification given to a partnership by the state of residence and the source state, or a different tax treatment of a partnership while following the same classification, may give rise to risks of double taxation and double non-taxation.67 In 1999, the OECD identified these issues and proposed solutions. The general principle of the partnership report68 is that the source state follows the qualification of the state of residence. It is decisive whether income at the level of a resident of a Contracting State is taken into account as their income. If such a resident can be identified under national law, the source state must recognise this.

Art. 1, par. 2, OECD MTC incorporates the principles included in the partnership report into the OECD MTC. Under this provision, treaty benefits only apply to income of transparent entities if that income is treated as the income of a resident of a state for domestic tax purposes. With this, the OECD wants to ensure that treaty benefits are only granted in appropriate cases. In addition, this provision aims to ensure that treaty benefits will not be granted if neither Contracting State allocates income under its domestic tax law to a resident of its state.69 The partnership report only dealt with arrangements involving hybrid entities, whereas art. 1, par. 2, OECD MTC also applies to hybrid arrangements.70

Problems in the context of the application of tax treaties to partnerships include group situations.71 The provision regulating the application of tax treaties to partnerships is aimed at the elimination of double taxation and tax avoidance.72 So, this provision is very much in line with the objectives of the OECD MTC.73

Saving clause

Art. 1, par. 3, OECD MTC contains a saving clause.74 This provision stipulates that the Convention does not restrict Contracting States in the taxation of their own residents, except when the provisions set out in the article are applied.75 The provision essentially provides that the Contracting States may apply their domestic anti-abuse provisions to residents without being restricted by the application of the tax treaty.76

A consequence of the saving clause is that countries may tax their residents on income from a CFC in the other state, if this is possible under national law.77 All EU countries78 and several other countries have rules to tackle tax avoidance through controlled foreign companies. Legislation on CFCs attributes income from a low-tax subsidiary controlled by the parent company to the parent company under certain conditions. This imputed income – pro rata to the interest – is then taxed in the state where the parent company is resident. Due to CFC rules, taxation at the level of the parent company can already take place prior to an actual distribution of profits by the subsidiary. These rules aim to prevent the shifting of income to low-tax jurisdictions if there are no business considerations behind the shift.

The Commentary on art. 1 OECD MTC explicitly addresses the overlap between CFC legislation and tax treaties in situations where the tax treaty does not include a savings clause.79 The OECD takes the view that CFC legislation should not lead to a conflict with tax treaties. According to the OECD, CFC legislation should be applied entirely separate from tax treaties.80 The underlying justification seems to be that these rules are designed to combat tax avoidance and to protect against erosion of the domestic tax base.81 If CFC legislation does not lead to a conflict with tax treaties, the CFC legislation can be applied without any tax treaty influence. The application of CFC legislation in combination with tax treaties may therefore result in double taxation. Such double taxation will logically occur in group situations.

CFC double taxation may, for instance, occur within the EU when applying the CFC rules as prescribed by ATAD1. Under ATAD1, Member States have the possibility to choose between two variants of CFC legislation; potential double taxation seems to occur particularly in the context of applying Model A to indirectly held CFCs.82 Under the income approach of Model A, certain undistributed income of the CFC is included in the tax base of the taxpayer.83 Double taxation then occurs, for instance, when an entity in EU Member State A holds the shares in a CFC through an intermediate holding company in EU Member State B. When applying Model A in both EU Member States, the income of this CFC is taxed twice in both EU Member States.84 At EU level this double taxation has been recognised and accepted. An OECD compliant tax treaty does not provide for relief of double taxation in such situations either.85