Treaty Application for Companies in a Group (FM nr. 178) 2022/1.3:1.3 Assessment framework

Treaty Application for Companies in a Group (FM nr. 178) 2022/1.3

1.3 Assessment framework

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To assess whether the current treaty rules of the OECD MTC for group entities are in line with the object and purpose of tax treaties, or whether changes are required, this research assesses the objectives of tax treaties as contained in the OECD MTC.1 From the title and preamble of the OECD MTC it follows that the objectives of the Convention are to eliminate double taxation with respect to taxes on income and capital, without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance. The context of these purposes is the desire of the Contracting States to further develop their economic relationship and to enhance co-operation in tax matters. Double taxation can increase the overall tax burden of companies and can therefore negatively impact capital investments. The motivation to enter into a tax treaty is thus to promote and reduce barriers to international trade and investment.2

The OECD MTC focuses on eliminating international juridical double taxation.3 The OECD defines international juridical double taxation as the imposition of comparable taxes in two or more states on the same taxpayer in respect of the same subject matter and for identical periods.4 The importance of avoiding double taxation is justified by the OECD by pointing out the obstacles it creates to international trade.5 The primary focus is thus on the development of the economic relationship of treaty states as a result of unhindered cross-border movements of trades, capital and people.6 According to the OECD member countries, it is desirable to clarify, standardize and confirm the tax situation of taxpayers, who carry out commercial, industrial, financial or other activities in other countries. Therefore, there should be common solutions for identical cases to eliminate double taxation.7 Through the use of tax treaties, Contracting States aim to prevent cross-border services, trade and investment from being hampered by the risk of double taxation due to the concurrence of two tax systems.8 By stimulating cross-border trade and investment, the OECD MTC can contribute to the overall goal of the OECD: ‘shape policies that foster prosperity, equality, opportunity and well-being for all.’9 The underlying presumption seems to be that tax treaties stimulate job creation and positively influence economic growth.10

As indicated, the second11 objective that states pursue through the agreement of tax treaties is to make sure no opportunities for non-taxation or reduced taxation are created through tax evasion12 or tax avoidance.13 This second objective is explicitly included in the title and preamble of the OECD MTC since 2017.14 The adjustment is a result of the OECD’s BEPS project.15 More specifically, the adjustment to the title and preamble follows from the report on Action 6, aimed at preventing the granting of treaty benefits in inappropriate circumstances.16 Taxpayers can take advantage of the international tax treaty network and can structure their business operations to benefit from, e.g., a lower withholding tax rate (treaty shopping).17 Moreover, persons can, inter alia, seek to circumvent treaty limitations.18 This can lead to the granting of tax treaty benefits in inappropriate circumstances. Additionally, although tax treaties were originally designed to prevent double taxation, they can also result in double non-taxation.19 The reason for this is that tax treaties restrict the application of domestic law. If a Contracting State relinquishes its taxing power in full or partially to the other Contracting State through a tax treaty, this is usually based on the assumption that the other state will tax the component of the income. If this is not the case, situations of double non-taxation may arise. This is especially the case under the application of an exemption system.20

There is a difference between the terms double non-taxation and non-taxation. However, the OECD seems to use them interchangeably.21 Non-taxation as such involves the perspective of only one state, while double non-taxation refers to the result of a given event that is not taxed by both states involved in a cross-border situation. The terms are related: double non-taxation requires the existence of non-taxation.22 Sovereignty exercised by different states can lead to non-taxation domestically, and subsequently to double non-taxation across borders.23 The OECD MTC preamble solely refers to non-taxation and not to double non-taxation. The underlying objective of the amendment to the preamble was to clarify that tax treaties are not intended to be used to generate double non-taxation.24 Additionally, as the OECD MTC entails a cross-border perspective, it seems logical to interpret the objective as preventing both non-taxation and double non-taxation in cases of tax avoidance, where double non-taxation seems the main issue.25 In this regard, a distinction can be made between intended and unintended double non-taxation. Double non-taxation can be the result of the tax policy of one or both of the Contracting States.26 In that situation the outcome is intended: there is no abuse.27

The question arises whether equal weight should be given to both objectives. It is clear that the original purpose of the OECD MTC was the prevention of double taxation, to which the prevention of tax evasion and tax avoidance was added later. The OECD writes in the introduction to the OECD MTC that ‘these are the main purposes’, which seems to imply that equal value is given to both purposes. In contrast, the OECD also writes:28

‘The principal purpose of double taxation conventions is to promote, by eliminating international double taxation, exchanges of goods and services, and the movement of capital and persons. As confirmed in the preamble of the Convention, it is also a part of the purposes of tax conventions to prevent tax avoidance and evasion.’

From the foregoing it seems that the OECD attaches the most importance to the prevention of double taxation.29 Does this mean that, in situations where there is concurrence between the two, in the eyes of the OECD the prevention of double taxation is more important than the prevention of tax evasion and tax avoidance? If so, it could be claimed that if there is double taxation due to the application of a treaty rule that aims at combatting tax evasion and tax avoidance, the elimination of double taxation should still be provided for. What would this mean in practice? This can best be explained by a simple example. If a dividend payment is made to an entity that is not the beneficial owner of that dividend, it would be in line with the goal to combat tax avoidance to not grant a lowered withholding tax rate nor grant a credit at the level of the recipient. This would of course lead to double taxation.30 Avoiding this double taxation could be done by granting a lowered withholding tax rate and a credit at the level of the recipient in line with the regular rules of the tax treaty. However, such a solution would make the anti-avoidance rule useless. This simple example indicates that it is not possible in each situation to pursue both objectives. The only logical conclusion is that in tax avoidance situations, the weight of the principal purpose of the treaty (avoiding double taxation) needs to be reduced in favour of the ancillary purpose (preventing tax evasion and tax avoidance).31 In case the anti-avoidance rule leads to a situation in which there is no longer double non-taxation (i.e., single taxation), there is no conflict between the two objectives.

The aforementioned objectives of a tax treaty follow from the OECD Commentary. There is no international consensus regarding the nature and purpose of tax treaties.32 In literature additional, mainly overlapping or more or less interim objectives can be found. Narsesyan states that the role of the international tax architecture is in essence to avoid excessive taxation of a single activity, as well as to prevent non-taxation of a business activity.33 According to Bennet, tax treaties aim to provide certainty and predictability for foreign investors. This contributes to the economic relations between the countries that are parties to the treaty.34 Due to the network of bilateral tax treaties a more predictable legal environment for international businesses exists.35 Changes to the bilateral network negatively influence legal certainty. Tax treaties increase the stability in tax systems, as they are less often changed than domestic laws.36 Van Weeghel argues that the OECD MTC achieved structure – beyond its objectives. Moreover, it focused the minds of legislators. Additionally, it presented a platform in which member countries worked on improving the model. The OECD became the structure and platform via which international standards were explored and formulated.37 Leduc and Michielse are of the opinion that tax treaties intend to benefit taxpayers that are resident in either or both Contracting States.38

Additionally, there are authors who consider the relatively flexible rules on the elimination of double taxation as included in the OECD MTC – which can also apply if there is no double taxation – to be insufficient. Norr is of the opinion that one of the functions of tax treaties is that income should at least be taxed once.39 Avi-Yonah also states that the OECD MTC is based on the single tax principle.40 The single tax principle entails that all income should be subject to tax only once, i.e., there should be no double taxation nor double non-taxation.41 It intends to eliminate juridical double taxation.42 According to Avi-Yonah and Panyai, as tax treaties are based on the single tax principle, a reduction of source taxation should be premised on actual taxation by the residence country.43 The single tax principle appeals to common sense and can be seen as improving efficiency.44 It seems that ensuring single taxation – even though in principle it is a logical45 and desirable principle – is not a function of the Convention.46 If this would have been an objective of the OECD MTC, this would have been reflected in either the residence article47 or the article on the elimination of double taxation.48 The preamble to the OECD MTC too states that non-taxation is solely contrary to the aim and purpose of the model in the case of tax evasion or avoidance.49

In contrast, some authors claim that the purpose of tax treaties no longer is to avoid double taxation, as the elimination of double taxation is already included in national legislation.50 Most capital-exporting countries for instance fully exempt foreign-source active business income or if they do tax the profits, they usually provide unilateral relief for double taxation.51 In this view the principal purpose of tax treaties is solely to allocate taxing powers between the residence country and the source country.52 If domestic law already eliminates double taxation, distribution rules in essence only reduce taxation in the source country for the benefit of the residence country.53 As double taxation is less problematic due to these unilateral rules, it is even questioned whether the presence of tax treaties is justified at all.54 Also, it could be argued that, as tax policy is and remains a matter of domestic tax law, on which there is no international agreement, tax treaties are by no means redundant. Furthermore, tax treaties do more than solely allocating taxing rights, as they provide a legal basis for dispute resolution. Moreover, as already indicated above, they provide stability and reassurance to taxpayers.55

Various authors emphasise the more formal or administrative aspects of tax treaties. Treaties can assist countries in monitoring and enforcing tax compliance.56 They can, e.g., play a role in detecting money laundering.57 Lang and Owens state that tax treaties provide a framework in which tax authorities can minimize disputes and resolve them when they arise. Furthermore, tax treaties lead to a legal framework for cooperation between tax authorities to counter offshore non-compliance.58 Kemmeren views the elimination of discriminatory taxation as one of the objectives of the OECD MTC.59 Additionally, tax treaties can lead to reducing bureaucratic hassle, coordinating tax terms and a redistribution of tax revenues.60

The OECD MTC does more than just serving as a starting point for treaty negotiations.61 Even though it is not an objective as such,62 as a result of tax treaties domestic tax laws have been influenced. This has led to significant standardization and convergence.63 An example of this is the, to a large extent universal, use of the permanent establishment concept throughout the world. The tax treaty network therefore is a clear example of international cooperation. This could even be used to establish a new international tax regime: the treaty rules allocating the taxing rights in line with the OECD MTC would then establish the international tax regime.64

Sadiq views the equitable allocation of taxing rights between jurisdictions as an inherent objective of tax treaties.65 With the term equitable Sadiq refers to the doctrine of inter-nation equity as described by Musgrave and Musgrave.66 Inter-nation equity concerns the allocation of national gains and losses.67 It seeks a fair allocation of tax between states and is thus a key element in the debate with respect to dividing taxing rights between residence and source countries.68 The foundations for the OECD MTC were laid in the early twentieth century.69 In line with the benefits principle,70 taxation in the country of source was justified for active income, while the right to tax passive income was primarily assigned to the residence jurisdiction.71 This approach to taxing active and passive income was believed to be easier to identify and enforce.72 The fact that active income may be taxed in the source country, while passive income may primarily be taxed in the residence country (the investor country) is ultimately a choice that has been made. It is based on best practices and political compromises, rather than principles.73 In my view, the ‘cubbyhole approach’ that is applied for income tax treaties, with a different treatment for different types of income, does not contribute to an equitable allocation of taxing rights.74 Additionally, developments such as the digitalisation of the economy show that the current allocation rules are not suitable to equitably allocate taxing rights.

In essence, the objectives of the OECD MTC are linked to the concept of neutrality.75 Neutrality requires that there is no influence on the decision of a person to act in a specific manner. The underlying basic criterion of neutrality is efficiency of capital allocation.76 Efficiency is based on the assumption that productivity will be highest if income producing factors are distributed by the market without interference.77 Business decisions should be made because of economic considerations: capital should be invested where returns are highest.78 A tax-neutral system means that the choice of a taxpayer for, e.g., a certain organizational form or choice of location of an investment79 is not influenced by tax considerations.80 Unrelieved double taxation leads to an increase of the tax burden and can negatively impact capital investments.81 It is argued that achieving international tax neutrality would require a unified tax base and tax rate.82 However, taxes can never be fully neutral. As far as efficiency is desirable, they should be drafted to minimize distortions.83 For the remainder of this research, the term neutrality is therefore understood to mean that taxes are levied in a way in which economic processes are distorted as little as possible.84 This means that there is neutrality – insofar as possible – as to where to produce and sell, and also that there is neutrality of legal form.85

The goal of tax treaties is to promote cross-border trade by removing tax obstacles and as such promote an optimal allocation of profits while minimizing distortions caused by tax systems.86 If a treaty rule ensures the economic objective of locational neutrality,87 it is said to promote the most efficient allocation of resources and thus maximize global welfare.88 The concept of locational neutrality89 is traditionally analysed from two different perspectives: the perspective of Capital Import Neutrality (CIN) and of Capital Export Neutrality (CEN).90 Both corresponding methods for the elimination of double taxation (the exemption method and the credit method, respectively) are reflected in the OECD MTC.91 Locational neutrality is mainly the role of the residence state.92

The idea behind CIN is that investments in a certain country are treated the same for tax purposes, irrespective of the country of origin. In other words, a subsidiary should have the possibility to compete in the foreign market on equal terms with local companies. Thus, the subsidiary should only be subject to local tax and an exemption method should be applied in the home country. A CIN system requires that the same marginal tax rate applies to all investments in a country, irrespective of the residence of the investor. Under a CIN system, the tax systems of the two treaty states should not lead to a tax advantage or disadvantage for the investment in one of the countries for a non-resident investor in comparison to a resident investor. The benefits principle can be recognized in this approach.93

A system based on CEN requires that the combination of the tax systems of the two treaty states do not provide a tax advantage or disadvantage for a resident of a country to invest at home, rather than in the other country. Under such a system, investments from the state of the investor should be treated the same for tax purposes regardless of their destination. Companies that invest abroad should pay the same tax as companies that invest exclusively in the home country. Thus, taxation should not influence the decision where to invest. This can be achieved by taxing the company for its worldwide income and providing a full tax credit94 for taxes paid abroad. Under this system, worldwide income is taxed at the home state's tax rate. The ability to pay principle can be recognized in this approach.95

As indicated, the primary right to tax business income is assigned to the source country. However, passive income (interest, dividends and royalties) may primarily be taxed in the residence state. The question is whether this choice is one that contributes to an efficient allocation of production factors. Economists see allocation as optimal when the use of production factors results in the best possible productivity.96 There is discussion on whether this is achieved via CIN or CEN.97 Both CIN and CEN seem insufficient to provide – insofar as possible – tax neutrality, as solely one-sided movements of production factors are addressed. Tax systems that promote CIN distort outward investments (e.g., by not allowing the import of losses). Tax systems that promote CEN distort inward investments (e.g., by imposing an additional tax at the level of the country of residence and thus creating a competitive disadvantage for taxpayers in the source country).98

In summary, the main objectives of tax treaties according to the OECD are to avoid double taxation in order to encourage cross-border activities, without creating opportunities for non-taxation or reduced taxation through tax evasion or tax avoidance. In essence, this means the OECD strives for a neutral system: a system in which economic process are distorted as little as possible, which requires that there is no double taxation nor unintended double non-taxation. The current treaty rules for group companies as included in the OECD MTC are reviewed in this research against the two goals as set by the OECD,99 in light of the overarching neutrality principle. Additionally, any new proposed rules will be assessed against this framework.

It should again be emphasised that a group approach at a tax treaty level as such does not solve the issues with respect to the tax treatment of groups of companies. This would have to be reflected in national law. In this regard, also the concurrence with European Union (EU) law will be discussed. If new treaty rules were to lead to conflicts with EU law, this would mean the internal market would be hindered, which would be at odds with the neutrality aim of the OECD MTC. Additionally, an analysis will be made of how a national tax system that perfectly matches a group approach at a tax treaty level would look like. If the new rules are not reflected in national law, the objectives of the OECD MTC cannot be achieved. Apart from that, the practicability of the system will be part of the analysis: treaty rules should be clear and enforceable. A group concept is practicable if there is a clear definition for tax administrations and taxpayers, with adequate control possibilities for tax administrations.

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