THE UN Model tax Convention has a tortious history. It was conceived specifically to deal with the special needs of the newly decolonized countries of the 50s and 60s that now form the bulk of the 'developing countries'. It may be noted that the first meeting of the Committee of ad-hoc experts took place in 1968. At that time, it was universally accepted that the model of double tax Convention that prevailed amongst the OECD countries was not particularly suited for the developing countries. At its inception, however, the discourse in the UN Committee was dominated either by officials or scholars from the developed world and although the UN Model gives a wee bit more taxing power to the Source States, since its inception, there have been deliberate efforts to limit the differences between the OECD and the UN Model.
The call from developing countries under G-77 to give more resources to the UN tax committee so that the same could work more effectively, has been successfully thwarted by the rich countries that obviously are the major donor countries. In fact, a Trust Fund for International Cooperation in Tax Matters was established in July 2006, in order to support the activities of the Committee of Experts on International Cooperation in Tax Matters. It may also be noted that in the third international conference on financing for development at Addis Ababa held in 2015, an appeal was made for voluntary contributions. It is also worthwhile to note that India became the first country to make such a donation of 100000 USD towards the fund in June, 2017. Web search has not shown any other contribution from other countries so far.
In the meantime, the OECD as an organisation came up with its BEPS project that proposed a wide range of changes with a view to control or limit the phenomenon of base erosion and profit shifting (BEPS) as understood in these countries. After concluding the work for two years by the OECD which had also roped in non-OECD G-20 countries, it was time to implement the recommendations. To give a veneer of acceptability to the developing countries that had no say in the development of the recommendations, the OECD also formed what is known as the 'inclusive framework' where there is some proforma participation by the developing countries supposedly on an equal footing. The idea is simple. If everybody accepts and implements the recommendations of the OECD, it gains complete control in setting the standards of the international tax and in course of time, one can argue for dismantling the UN Committee itself on the avowed ground of duplication of work.
In the context of the OECD BEPS project, it may also be interesting to note that the UN had formed a subcommittee on BEPS and that subcommittee had prioritized some important issues and had sent a questionnaire that was also responded to by some of the developing countries. These responses indicated that transfer pricing, interest limitation, intangibles, treaty abuse, etc., as identified by the sub-committee were indeed of importance to these respondents from developing countries. That apart, action 7 relating to avoidance of PE status and action 1 relating to digital economy were also considered very important. Unfortunately, the OECD work in these last two areas were the least satisfactory.
At the outset, it may also be noted that source country tax base erosion may also arise because of the current distribution of taxing rights. The OECD, however, had made it clear that it was not going to address the issue at all even though this was of vital importance to many developing countries. The BEPS Action Plan explicitly stated that its actions "are not directly aimed at changing the existing international standards on the allocation of taxing rights on cross border income".
It is in this scenario, that the 2017 update to the UN Model that was hanging fire for quite some time, has finally been released on the 18th May, 2018. The document is more than 800 pages long and it would take some time for anyone to go through the contents of the entire document to understand the important aspects of the new Model and its Commentary. However, a few preliminary observations will be in order.
The main differences between the 2017 UN Model and the 2011 UN Model, are indicated as follows
- A modified title of the Convention and a new preamble of the Convention emphasizing that treaties should not create opportunities for tax avoidance or evasion, including through treaty shopping;
- A new version of Article 1 that includes a fiscally transparent entity clause, and a saving clause which clarifies that residence taxation is generally preserved under tax treaties;
- A modified version of Article 4 that includes a new "tie breaker" rule for determining the treaty residence of dual-resident persons other than individuals;
- A modified version of Article 5 to prevent the avoidance of permanent establishment status;
- A modified Article 10 to change the circumstances in which a lower rate applies for dividends on direct ownership of shares above a 25% threshold;
- A new Article 12A to provide for source taxation of fees for technical services;
- A new version of Article 13, paragraph 4 to modify the scope of the land-rich company rule;
- A modified version of Article 13, paragraph 5 for consistency with Article 13, paragraph 4;
- Changes to Articles 23A and 23B to clarify that there is no obligation to provide relief for tax imposed on a solely residence basis;
- A new Article 29 that contains provisions relating to entitlement to treaty benefits. These include a limitation on benefits rule, a third state permanent establishment rule and a general anti-abuse rule.
As can be observed, most of these changes emanate from the OECD BEPS report. Where the 2017 UN Model makes a departure is the adoption of a new Article 12A relating to fees for technical services. Although there were many twists and turns, this new article is being projected as the panacea for the developing countries getting an additional taxing right over an important item of income. It will be therefore worthwhile to consider this article in some detail.
Readers may be aware that India had introduced a source rule way back in 1976 through an amendment in section 9 of the Income Tax Act [9(1) (vii)] that deemed fees for technical services to accrue or arise in India. Those days there were not too many tax treaties and the concept of business connection that gave taxing powers to India could not capture huge payments that went out of India whenever new projects, machinery and technology was brought into the country. There was a separate source rule for royalties in section 9(1) (vi).
India also started to incorporate a specific article relating to fees for technical services in its tax treaties. The article either was a stand alone or occasionally combined with the article on royalties. The article gives a secondary taxing right to the source state to tax income from the fees for technical services at a reduced rate on gross basis. The standard definition of the term was more or less as follows:
"The term fees for technical services as used in this Article means payments of any amount to any person other than payments to an employee of the person making payments, in consideration for the services of a managerial, technical or consultancy nature, including the provision of services of technical or other personnel."
However, the United States was not willing to concede to India's demands to have an article on fees for technical services with a broad remit and ultimately a compromise was found by restricting the ambit of the operation of the article and calling it fees for included services and the determining factor in such cases was whether technology was made available by the service provider to the users. This restricted definition ultimately got extended to many of the then OECD member countries either as part of the negotiation process or through the operation of the MFN clauses that some of these treaties contained. Indian case law database is replete with cases relating to fees for technical services and the main issue in these cases were whether the make available clause is satisfied in the facts of a particular case or not.
In this context, it is also interesting to note that at the United Nations where service taxation was an important issue for the developing countries, the developed countries were particularly reluctant to grant this taxing right to the developing countries. In fact, even now the UN Model 2017 gives an option to countries not to adopt the article. The Commentary mentions in detail the reasons of the opposition of the developed countries and some of these are as follows:
- Taxation of fees for technical services is warranted only when the service provider has a sufficient nexus to the payer's State, which typically is in the form of a permanent establishment or fixed base.
- Mere deductibility of a commercially justified payment cannot be equated to harmful base erosion, and is therefore not a sufficient reason for taxing that payment in the same State.
- The term "technical services" as used in the Article is not adequately defined and would result in increased uncertainty, inconsistent treatment, and lengthy disputes between taxpayers and tax authorities.
- The imposition of a tax on a gross basis denies the taxpayer the ability to take into account expenses that were incurred in connection with the provision of the services thereby opening the possibility of double taxation.
- Foreign Service providers could pass added tax costs on to the consumer through "gross-up" clauses in contracts thereby making it more expensive to purchase the services. This can put a foreign service provider at a competitive disadvantage, effectively foreclosing access to a market that imposes such a withholding tax and restricting the consumer's legitimate choice of suppliers.
- The inclusion of Article 12A could lead to trade distortions as the taxation of goods and services would operate on a different basis.
- Any expanded taxing jurisdiction on fees for technical services would amount to an unjustified shift of the balance of taxation from the place where services are provided to the place where services are consumed.
Ultimately however, most of the member countries of the UN rejected such arguments and decided in favour of a new article. They countered the arguments of the developed countries in the following terms:
- Under the current rules, income from services is taxable exclusively by the Residence State except where there is a PE. However, the rapid changes in modern economies, particularly with respect to cross-border services, has now made it possible for an enterprise resident in one State to be substantially involved in another State's economy without a permanent establishment or fixed base.
- Generally speaking fees for technical services cannot also be taxed as royalties under article 12, particularly in the case of mixed contracts. In any case, difficult disputes arise in such cases.
- Fees for technical services are usually deductible against a country's tax base if the payer is a resident of the country or a non-resident with a permanent establishment or fixed base in the country. If the country is entitled to tax the non-resident service provider on the fees earned for the technical services, the reduction of the country's tax base by the deductible payments is offset by the country's tax on those fees.
- Where technical services are provided by an enterprise of one Contracting State to an associated enterprise in the other Contracting State, there is the possibility that the payments may be more or less than the arm's length price of the services.
- Within a multinational group, fees for technical services may sometimes be used to shift profits from a profitable group company resident and operating in one country to another group company resident in a low-tax country.
- The base erosion problem is especially serious from the perspective of developing countries, because they are disproportionately importers of technical services and often lack the administrative capacity to control or limit such base erosion and profit shifting through anti-avoidance rules in their domestic law and tax treaties.
- The inability of countries to tax fees for technical services provided by non-resident service providers under the provisions of the United Nations Model Convention before the addition of Article 12A may have given non-resident service providers, in certain circumstances, a tax advantage over domestic service providers.
- If base erosion is a sufficient justification for the taxation of income from employment under Article 15 and directors' fees and remuneration of top-level managerial officials under Article 16, there is no reason as to why the same will not constitute sufficient nexus for FTS.
- As for the possibility that FTS may be grossed up, the same is a factor that may be taken into account in establishing the maximum rate of tax.
- The possibility that FTS may be subject to excessive or double taxation is reduced or eliminated under Article 23 (Methods for the Elimination of Double Taxation).
As a result of these considerations, the United Nations Committee of Experts identified fees for technical services as a matter of priority to be dealt with as part of its larger project on the taxation of income from services under the United Nations Model Convention and after considerable study and debate, having due regard to all the arguments for and against the expansion of taxing rights with regards to services and the majority of the nations decided to adopt the following new article:
Article 12A
FEES FOR TECHNICAL SERVICES
"1. Fees for technical services arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.
2. However, notwithstanding the provisions of Article 14 and subject to the provisions of Articles 8, 16 and 17, fees for technical services arising in a Contracting State may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner of the fees is a resident of the other Contracting State, the tax so charged shall not exceed ___ percent of the gross amount of the fees [the percentage to be established through bilateral negotiations].
3. The term "fees for technical services" as used in this Article means any payment in consideration for any service of a managerial, technical or consultancy nature, unless the payment is made: (a) to an employee of the person making the payment; (b) for teaching in an educational institution or for teaching by an educational institution; or (c) by an individual for services for the personal use of an individual.
4. The provisions of paragraphs 1 and 2 shall not apply if the beneficial owner of fees for technical services, being a resident of a Contracting State, carries on business in the other Contracting State in which the fees for technical services arise through a permanent establishment situated in that other State, or performs in the other Contracting State independent personal services from a fixed base situated in that other State, and the fees for technical services are effectively connected with: (a) such permanent establishment or fixed base, or (b) business activities referred to in (c) of paragraph 1 of Article 7. In such cases the provisions of Article 7 or Article 14, as the case may be, shall apply.
5. For the purposes of this Article, subject to paragraph 6, fees for technical services shall be deemed to arise in a Contracting State if the payer is a resident of that State or if the person paying the fees, whether that person is a resident of a Contracting State or not, has in a Contracting State a permanent establishment or a fixed base in connection with which the obligation to pay the fees was incurred, and such fees are borne by the permanent establishment or fixed base.
6. For the purposes of this Article, fees for technical services shall be deemed not to arise in a Contracting State if the payer is a resident of that State and carries on business in the other Contracting State through a permanent establishment situated in that other State or performs independent personal services through a fixed base situated in that other State and such fees are borne by that permanent establishment or fixed base.
7. Where, by reason of a special relationship between the payer and the beneficial owner of the fees for technical services or between both of them and some other person, the amount of the fees, having regard to the services for which they are paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In such case, the excess part of the fees shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of this Convention."
As can be seen, the language and structure of the new Article is more or less on the lines of the standard article on FTS as found in some of India's treaties and it seems that India had played an important part in having the article incorporated in the UN Model, 2017. How far this will be adequate in solving the intractable base erosion problem is however not certain. |
