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Home >> TII EDIT
The 2021 UN Model
By D P Sengupta
Apr 30, 2022

THE UN Committee of Experts on international Cooperation in tax matters having in April, 2021 approved the final version of the UN Model, 2021, the UN Model Double Taxation Convention between developed and developing countries, was formally launched on the 26 th April, 2022 . This is a rather unusual occurrence as it is normally the OECD that comes out with its versions that are more often than not followed by the UN tax Committee. The same also happened in 2017 and this is perhaps the first time that the UN Committee has come out with its revised model ahead of the OECD. To be fair, the OECD has been taking a multitude of initiatives and most notably, the effort to finalise its two-pillar solution (whether comprehensible or not) to the problematic area of taxation of digital economy involving the members of the Inclusive Framework, the majority of whom are from the developing countries. Such success of the OECD, if indeed achieved by whatever means, will enhance its prestige and its claim of inclusivity as opposed to the current appellation that is generally applied to it- 'a club of the rich'. But first, let us have a look at the main changes brought about by the new UN Model.

There are essentially three areas in which significant changes have been made in the current version - the most important and the most discussed being the insertion of a new Article 12B relating to taxation of the automated digital services. The other two areas relate to the taxation of collective investment vehicles and pension funds and their investors and, the inclusion of two clauses in article 13 relating to capital gains that deals with the capital gains from state granted rights and the famous offshore indirect transfer. (OIT)

In so far as collective investment vehicles (CIV)are concerned, the OECD model 2017 has already dealt with it mainly in its commentary. A collective investment vehicle is essentially a fund that pools the investment of many investors. There are often domestic legislations to deal with such vehicles but in a cross-border situation, tricky issues often arise- whether the CIV can be called a 'person' for the purpose of a tax treaty, if it is a person, then whether it is a 'resident' of a contracting state 'liable to tax'. Besides the structure of the CIVs also varies- a trust structure or partnership, a joint venture and others. Questions arise as to whether these are transparent or pass-through entities or opaque ones. Further question then arises regarding the beneficial ownership and whether the treaty benefit should be given to the CIV or the investors. Other issues, particularly concerns relating to treaty -shopping also arise. Some of these issues have also arisen in the Indian context.

Considering the fact that both CIVs and pension funds actually pool resources from a multitude of investors, it is a fact that the CIVs and funds now constitute a significant source of foreign investment and without some clarification might not be willing to invest in a particular jurisdiction. In the Indian context we keep hearing complaints to this effect and the domestic tax law has made some changes in recent years in this regard. Because of the importance of the CIVs and funds, the OECD Model has extensively discussed the various issue that may arise albeit in the Commentary to Article 1 and article 28 relating to limitation of benefits. But there is no straightforward provision incorporated in the Model.

The 2021 UN Model for the very same reason also discusses the pros and contras of giving treaty benefits particularly from the perspective of developing countries whose need for investments need to be balanced with the need for revenue both ultimately contributing to reach the targets for achieving the Sustainable Development Goals (SDG).

We therefore find a new clause in Article 1 of the UN Model - clause 4, which says [ Provision dealing with the application of the Convention to collective investment vehicles ] without actually spelling out the contents but with a caveat in the footnote that the various forms that such a provision could take are discussed in the section "Collective Investment" in the Commentary on Article 1 and considering that the domestic tax rules applicable to various forms of collective investment vehicles in the Contracting States and the disparities in the importance of investment by such vehicles in each of these States as well as other policy or administrative considerations may not justify the inclusion of a provision on collective investment vehicles in a bilateral tax treaty or may require different provisions aimed at different categories of such vehicles.

In so far as pension fund is concerned, we notice two changes following the lead taken by the OECD in 2017. Article 4 now in clear terms includes a recognised pension fund as a resident of a Contracting State and the term is defined in Article 3(g) as follows:

"the term "recognized pension fund" of a Contracting State means an entity or arrangement established in that State that is treated as a separate person under the taxation laws of that State and

(i) that is established and operated exclusively or almost exclusively to administer or provide retirement benefits and ancillary or incidental benefits to individuals and that is regulated as such by that State or one of its political subdivisions or local authorities, or

(ii) that is established and operated exclusively or almost exclusively to invest funds for the benefit of entities or arrangements to which subdivision (i) applies

Correspondingly it is also accorded the entitlement to treaty benefits in Article 4.

Automated digital services- Article 12B

Adoption of article 12B relating to automated digital services in the UN Model, in a way, demonstrates the frustration of the developing countries with the OECD solution to the problem of taxing income in a digitalised economy. The OECD keeps on insisting that its work is inclusive and provides an ideal solution to a world problem. But the complexity of its proposed solutions, the arrogance of its proponents and the constant shifting of stance at the behest of its dominant western powers, perhaps prompted the UN tax committee to search for an alternative solution that is based on the well-known bilateral model and time-tested method of withholding on a gross basis at a moderate rate. The OECD solution will require another MLI with its associated problems. Even now, the MLI version 1 has not been adopted by many participants.

As stated in the Commentary, modern methods for the delivery of services allow non-residents to render substantial services for customers in the other country with little or no presence in that country and such ability to derive income from a country with little or no physical presence in that country was considered by the Committee to justify source taxation of income from automated digital service and the proposed Article 12B does not require any particular threshold, such as a permanent establishment, fixed base, or minimum period of presence, in a Contracting State as a condition for the taxation of income from automated digital services.

The main elements of the Article are as follows:

12B (1). Income from automated digital services arising in a Contracting State, underlying payments for which are made to a resident of the other Contracting State, may be taxed in that other State .

2. However, (…) income from automated digital services arising in a Contracting State may also be taxed in the Contracting State in which it arises and according to the laws of that State, but if the beneficial owner of the income is a resident of the other Contracting State, the tax so charged shall not exceed ___ per cent [the percentage is to be established through bilateral negotiations] of the gross amount of the payments underlying the income from automated digital services

3. The provisions of paragraph 2 shall not apply if the beneficial owner of the income from automated digital services, being a resident of a Contracting State, requests the other Contracting State where such income arises , to subject its qualified profits from automated digital services for the fiscal year concerned to taxation at the tax rate provided for in the domestic laws of that State. If the beneficial owner so requests, (…), the taxation by that Contracting State shall be carried out accordingly. For the purposes of this paragraph, the qualified profits shall be 30 per cent of the amount resulting from applying the profitability ratio of that beneficial owner's automated digital services business segment to the gross annual revenue from automated digital services derived from the Contracting State where such income arises. Where segmental accounts are not maintained by the beneficial owner, the overall profitability ratio of the beneficial owner will be applied to determine qualified profits. However, where the beneficial owner belongs to a multinational enterprise group, the profitability ratio to be applied shall be that of the business segment of the group relating to the income covered by this Article, or of the group as a whole in case segmental accounts are not maintained by the group, provided such profitability ratio of the multinational enterprise group is higher than the aforesaid profitability ratio of the beneficial owner. Where the segmental profitability ratio or, as the case may be, the overall profitability ratio of the multinational enterprise group to which the beneficial owner belongs is not available to the Contracting State in which the income from automated digital services arises, the provisions of this paragraph shall not apply ; in such a case, the provisions of paragraph 2 shall apply

5. The term "automated digital services" as used in this Article means any service provided on the Internet or another electronic network, in either case requiring minimal human involvement from the service provider

6. The term "automated digital services" includes especially:

(a) online advertising services;

(b) supply of user data;

(c) online search engines;

(d) online intermediation platform services;

(e) social media platforms;

(f) digital content services

(g) online gaming;

(h) cloud computing services; and

(i) standardized online teaching services

7. The provisions of this Article shall not apply if the payments underlying the income from automated digital services qualify as "royalties" or "fees for technical services" under Article 12 or Article 12A as the case may be.

10. For the purposes of this Article, income from automated digital services shall be deemed not to arise in a Contracting State if the underlying payments for the income from automated digital services are made by a resident of that State which carries on business in the other Contracting State through a permanent establishment situated or performs independent personal services through a fixed base situated in that other State and such underlying payments towards automated digital services are borne by that permanent establishment or fixed base.

Article 12B (2) thus gives a secondary taxing right to the source country in respect of IDS. This is in the familiar pattern of the UN model with the rate of tax to be determined by negotiation. However, the Commentary suggests that the rate should be between 3-4%. Where, Article 12 B breaks new ground is that it gives an option to the MNC group to make a request to be taxed on net basis in respect of its ' qualified profits' from ADS, which is deemed to be 30% of the gross revenue derived from the source state. Besides, such net basis of taxation is allowed only when segmental accounts are available. Otherwise, the overall profitability of the group in respect of the ADS will be applied. If either the segmental accounts or the overall profitability of the group is not available, then this benefit of net basis of taxation will not be available.

The ADS is then defined as any service that is provided over the internet or other electronic network. Certain services are specifically included in the definition through 12A(6). While not in the Article itself, certain services are also specifically excluded in the Commentary and these are

(i) customized professional services;

(ii) customized online teaching services;

(iii) services providing access to the Internet or to another electronic network;

(iv) online sale of goods and services other than automated digital services; and

(v) revenue from the sale of a physical good, irrespective of network connectivity ("internet of things").

Article 12A(7) deals with the interaction between ADS and royalties and FTS and gives primacy to those provisions in case of overlap. 12A ((10) then gives the source rule in respect of the ADS which is deemed to arise if payment is made from the source state or from a PE in the source state bears the cost of the same.

This controversial UN proposal, of course, has sharpened the divide between the developed countries and the developing world. According to the new UN commentary lingo, a large minority expressed dissatisfaction with the proposed solution and the Commentary includes an alternate text to reflect their concerns. It is also not clear what the official Indian position will be.So far, India is going along with the OECD solution despite arguments about the practical utility of the same for the Indian revenue. If the OECD solution is accepted, questions may arise about the coexistence of such a solution with the one provided by the new article 12B.

Capital gains

That brings us to the changes made to the capital gains article in Article 13 which according to me, are the most important changes brought about in the 2021 Model. If one goes back to the taxation of capital gains from offshore indirect transfer in the Vodafone case, the Bombay High Court judgement essentially upheld the capital gains tax on the ground that if capital gains arising from a direct transfer of an asset is chargeable to tax, then the same would be chargeable to tax in case of indirect transfer through share sale in an offshore entity as well. Even though a lot of sound and fury was generated and the Hon'ble Supreme Court later held in favour of the taxpayer, the principle that incidence of direct and indirect transfer should be the same is in a way now recognised in the UN model. Earlier, the UN Model had granted this right to source states in case of indirect transfer of immovable property. Besides, the right to tax gains arising from the transfer of certain rights granted by the source state for exploitation by a non-resident is now specifically contained in a separate clause as follows:

Direct Transfer of certain rights granted by States

13(6). Gains derived by a resident of a Contracting State from the alienation of a right granted under the law of the other Contracting State which allows the use of resources that are naturally present in that other State and that are under the jurisdiction of that other State, may be taxed in that other State.

As explained in the Commentary, this would cover the alienation of rights such as fishing quotas granted by the State; the right to fell timber in a forest; the right to extract water ; the right to explore part of a territory of the State for oil, gas or minerals ; the right to install wind or tidal stream turbines in part of the territory of the State as well as the right to use all or part of the radio frequency spectrum in the State, including for cell phone purposes. The common features of these rights are that they allow the commercial exploitation of resources that are inextricably linked to the territory of a State and that the value of these rights consists of what are recognizably location-specific rents deriving from some government-issued license.

What is however, important to note is that this right can be exercised by the source state only if it has the corresponding domestic legislation in place. This is an aspect that has to be kept in mind while framing any necessary changes in the domestic law. Moreover, as emphasised in the Commentary, these rights must be directly transferred so as to come within the charge.

Offshore Indirect transfer


7. Subject to paragraphs 4 and 5, gains derived by a resident of a Contracting State from the alienation of shares of a company, or comparable interests of an entity, such as interests in a partnership or trust, may be taxed in the other Contracting State if

(a) the alienator, at any time during the 365 days preceding such alienation, held directly or indirectly at least ___ per cent [the percentage is to be established through bilateral negotiations] of the capital of that company or entity ; and

(b) at any time during the 365 days preceding the alienation, these shares or comparable interests derived more than 50 per cent of their value directly or indirectly from

(i) a property any gain from which would have been taxable in that other State in accordance with the preceding provisions of this Article if that gain had been derived by a resident of the first-mentioned State from the alienation of that property at that time , or

(ii) any combination of property referred to in subdivision (i)

The Commentary refers to this provision as granting the right to the source state from offshore indirect transfer and mentions that many developing countries asserted that they should get the right to tax the capital gains arising from such indirect transfers when the underlying assets are situated therein. The Commentary specifically mentions that the policy rationale behind the adoption of article 13(7) is the same as the policy rationale behind the adoption of article 13(4) in the UN Model which is that it is often relatively easy to avoid taxes on such gains through the use of a company incorporated for the purpose of holding such property and hence it is necessary to tax the sale of shares in such a company or other entities as mentioned in the clause.

Obviously, there were some members who opposed the inclusion of Article 13(7). The Commentary says a medium-sized minority of members of the Committee who opposed the inclusion of paragraph 7, were of the view that States should weigh a number of factors when considering whether to include paragraph 7 in their treaties, particularly from administrative and valuation point of view. Nevertheless, we now have a provision in the UN Model for taxing capital gains from offshore indirect transfer and also a specific claim for taxing capital gains from transfer of state-granted rights, developing countries should adopt the same at least while negotiating treaties with each other.

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