6.3.10.1 Elimination of double taxation without creating tax avoidance opportunities

Elimination of double taxation and tax avoidance, but fundamental flaw remains

As described per solution, the various more realistic changes to the OECD MTC that have been proposed, and which could be implemented in existing tax treaties via a second multilateral instrument, would contribute to achieving its objectives. Double taxation would be abolished in more situations, without creating tax avoidance opportunities. However, the ad hoc solutions described in this section do not lead to a comprehensive new approach. The fundamental flaw of the OECD MTC, the separate entity approach, would remain in place. For non-tax treaty situations nothing would be changed. Additionally, various problems identified in earlier chapters are not easy to solve in the current framework. This section provides an overview of the issues for groups of companies at the level of tax treaties that are not solved by the proposed changes.1

Remaining issue: the taxation of digital activities

The current OECD MTC solely allocates taxing rights to the supply side, while the developments regarding the digital economy stress the importance of attributing taxing rights to the market countries.2 Multinational companies are able to generate profits in the market jurisdiction without having any physical presence over there. To be able to allocate profits to the market jurisdictions, the rules governing the jurisdiction to tax should be amended.3 Furthermore, it should be determined how much profits can be attributed to a country in which there is a sufficient economic nexus. It is difficult to establish the exact amount of income that should be allocated to the market jurisdictions.

The EC tried to come up with a solution for the taxation of digital activities by introducing rules regarding a significant digital presence. The rules are meant to override tax treaties between EU Member States and would have to be included in tax treaties with non-Member States.4 The proposal requires ‘ring fencing’ of the digital economy, which does not seem possible. Moreover, adapting the functionally separate entity approach to the taxation of digital activities – as the EC proposes – seems very difficult.5

As described in par. 6.2.2.5, the Pillar One proposal of the OECD also does not seem to provide a feasible solution for the taxation of the digital economy to be inserted in existing bilateral tax treaties, inter alia, because it requires a multilateral approach.

The OECD is not the only organization that addresses the tax challenges of the digital economy. In 2021, the United Nations adopted a specific provision on automated digital services. The term ‘automated digital services’ is defined as ‘any service provided on the internet or another electronic network, in either case requiring minimal human involvement from the service provider.’6 This provision in essence adds another variant of passive income to the model. The article divides the taxing rights on automated digital services between the residence and the source country. Similar to the Pillar One proposal, the underlying idea is that taxing rights should be allocated to the market jurisdictions. The taxing rights of the source country are expanded by this provision, providing a ‘definite share’ for the market jurisdictions.7 The article allows a Contracting State to tax income from certain digital services paid to a resident of the other Contracting State on a gross basis, subject to the rate negotiated bilaterally. Furthermore, the provision includes the option for the taxpayer to pay tax on a net profit basis at the tax rate provided for in the laws of the source state.8 The profit is split between the residence and source country using a formula.9

A benefit of the provision on automated digital services is its simplicity. However, as is the case for the Pillar One proposal, first national taxing rights should be created. Additionally, the design of the provision raises some concerns (e.g., the term automated digital services will likely lead to discussions). Moreover, the taxing rights are solely linked to payments (i.e., does a local entity bear the expense), whereas for Pillar One the users of the services are of relevance, also if they do not pay for the services. Another objection against the new provision as designed by the United Nations is the fact that under application of the provision, the part of the worldwide profit that is assigned to the market jurisdiction is solely allocated to the entity that provides the service. Other entities within the chain that contributed to these services are not of relevance. As the service providing entity probably needed to pay an arm’s length amount to the various entities in the chain, not all income that is allocated to the market jurisdiction can be included in the domestic levy.10 Additionally, the provision only applies if the income is not already connected with a permanent establishment11 in the source country. If the income is connected to a permanent establishment, the arm’s length principle would apply.12 All in all, the provision on automated digital services does not seem the answer to the issues with respect to the taxation of digital companies.

Remaining issue: deductible interest

Intra-group loans can provide tax avoidance opportunities. For example, a group company in a low tax jurisdiction can be established to grant a loan to an entity in a high tax jurisdiction. This would lead to a deductible payment at a high rate, while the corresponding income would only be taxed at a low rate. Additionally, groups can use intra-group financing to generate tax exempt income.13 However, as tax treaties do not deal with the answer to the question whether payments are deductible or not (this is governed by national law),14 it does not seem possible to add a rule to the OECD MTC to limit the deductibility of interest expenses.15

Remaining issue: triangular cases

The bilateral nature of tax treaties leads to the existence of triangular cases in which double taxation and tax avoidance possibilities are the potential result.16 The OECD MTC only deals with issues related to triangular cases to a minor extent.17 Triangular cases are not limited to group situations. However, exploiting a triangular case for tax avoidance opportunities seems most easy in group situations. As indicated in par. 1.7, it is beyond the scope of this research to extensively discuss triangular cases and the possible solutions that exist. Therefore, solely reference is made to an earlier study in this field. Fett discusses the application of bilateral tax treaties in multilateral situations and proposes various treaty provisions to deal with several variants of triangular cases.18 Dealing with ‘typical’ triangular cases involving permanent establishments (other variants are dual resident triangular cases and reverse triangular cases), would, inter alia, require changes to the permanent establishment provision. To most comprehensively deal with these triangular cases, treaty benefits would have to be extended to permanent establishments.19 This would mean unrelieved double taxation would be prevented and opportunities for the improper use of the treaty are minimized. It seems to be a positive amendment, as it would contribute to the neutrality of the OECD MTC.