By Shaomei Chen
The 2017 edition of the OECD Model Tax Convention has recently been released, and it has incorporated the treaty-related measures resulting from the BEPS Projects. As said in the last post, one of the changes is that the tie-breaker rule contained in Art. 4(3) OECD Model (2014) in favor of the place of effective management (PoEM) for addressing dual residence has been replaced by a case-by-case approach (or the MAP tie-breaker rule), under which the determination of the residence is subject to a mutual agreement achieved by the competent authorities of the Contracting States. In the last post, I discussed some issues with respect to the application of the MAP tie-breaker rule. This post will focus on the effect of the MAP tie-breaker rule in a dual residence triangular structure.
Dual residence structures may be used for purpose of tax avoidance. It is because a dual resident company, for instance, incorporated in State I and effectively managed in State EM, may be entitled to the benefits of two sets of tax treaties: the tax treaties of State I with third states and the tax treaties of State EM with third states. The benefits of two sets of tax treaties may encourage abuse of dual residence. In the case where the old tie-breaker rule that prefers the PoEM criterion is included in the treaty between State I and State EM, the company is deemed to be resident only of State EM for the purpose of the treaty, and State I, as the loser state in respect of the residence of the company, may be prevented from taxing the income derived by that company unless the provisions of the treaty allow its taxation on a source basis. From a tax policy perspective, it seems inappropriate to continue to grant that company benefits of the treaties concluded by State I with third states. The OECD has recognized this issue. In the 2008 update to the Commentary on Art. 4 of the OECD Model, a sentence was added in paragraph 8.2 that:
“(The second sentence of Art. 4(1)) also excludes companies and other persons who are not subject to comprehensive liability to tax in a Contracting State because these persons, whilst being residents of that State under that State’s tax law, are considered to be residents of another State pursuant to a treaty between these two States.”
It means that the company cannot have access to a tax treaty between State I and a third state given that State I is the loser state for the purpose of the I-EM treaty, and this is based on an interpretation of the second sentence of Art. 4(1) in the application of the treaty between State I and a third state.
This commentary is controversial and has raised extensive discussion amongst the scholars. A particular concern is that this commentary is not in accordance with the plain wording of the second sentence of Art. 4(1), which provides that:
“(The term “resident of a Contracting State”), however, 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.”
The taxation of State I, in respect of income derived by the company, is restricted by the treaty between State EM and State I. State I can only impose tax to the extent not restricted by the provisions of the EM-I treaty. But does it mean that State I, as the loser state, may tax the dual resident company in respect of only income from sources in its jurisdiction? In the case where the presence of that company in State I constitutes a permanent establishment, State I is allowed to tax profits attributable to the permanent establishment, which may include income arising from a third state. Can profits attributable to the PE in State I arising from a third state be said to be “income from sources” in State I? These are some of the questions raised in respect of the 2008 Commentary on Art. 4 of the OECD Model. To avoid the interpretative issue, the 2016 US Model adopts a different wording and denies treaty access to person “who is liable to tax in respect only of income from sources in that Contracting State or of profits attributable to a permanent establishment in that Contracting State” (emphasis added)1. But as suggested by Vann, a more appropriate approach to the drafting of the treaty language should be to clearly exclude the dual resident case in the provision of Art. 4(1), a similar approach as referring to governments in Art. 4(1).2
Despite the controversy surrounding the interpretation of the second sentence of Art. 4(1), the cited OECD commentary (paragraph 8.2 on Art. 4) indeed provides a solution to tackle the abusive dual residence arrangement and allows the company to only have access to treaties concluded by State EM (and not those concluded by State I), as State EM is the winner state in respect of the company’s residence.
On the other hand, if the MAP tie-breaker rule is adopted in the treaty between State I and State EM, the said company is not necessarily resident only of State EM for the purpose of the I-EM treaty. The competent authorities of State I and State EM “shall endeavor to determine by mutual agreement the Contracting State of which such person shall be deemed to be a resident for the purposes of the Convention.” However, as discussed in the last post, in fact the competent authorities are not obliged to reach a mutual agreement, and even if an agreement can be concluded, it may take substantial time to finally complete a MAP. The company will remain a resident of both States I and EM for purposes of the I-EM treaty before an agreement is reached, and State I and State EM are not restricted by the I-EM treaty in taxing the income derived by the company. It would mean that the dual resident would not be excluded from the benefits of the tax treaties of each state with third states. There is no way to apply the second sentence of Art. 4(1) to the dual resident under the treaties of each state with third states and to deny the dual resident’s entitlement of the treaty benefits. The taxation of the third state, which is simultaneously bound by the treaty with State I and the treaty with State EM, is subject to the more restrictive treaty provision. Consequently, it may be beneficial for the dual resident company to leave the issue of dual residence unresolved, in particular when one of the residence states (either State I or State EM) offers preferential tax treatment to the dual resident under its domestic law.
When a mutual agreement is reached between the competent authorities of State I and State EM in respect of the residence of the company and one of the states is deemed to be the winner state, given that the third state may have already reduced its tax to the extent allowed by the treaty with State EM and also the treaty with State I, practical problem may arise given the time limits for tax assessment in the third state. The time limits in the domestic law of the third state may not allow reopening of tax assessment in the third state and adjust the tax result in accordance with the decision reached by State I and State EM in respect of the company’s residence. Article 25(2) of the OECD Model provides a clear rule that the Contracting States of the mutual agreement have to implement the agreement “notwithstanding any time limits in the domestic law of the Contracting States.”3 But this rule does not bind the third state, as it is not one of the Contracting States of the mutual agreement. Therefore, it is very likely that the dual resident company is still entitled to the benefits of two set of tax treaties concluded by each residence state with third states under the MAP tie-breaker rule. The whole discussion of the second sentence of Art. 4(1) in respect of dual residence situation seems to have less value. Yet, countries may rely on other anti-abuse provisions, for instances, the “Limitation on Benefits” (LOB) article4 and the “Principal Purpose Test” (PPT)5 to deal with the abusive arrangement of dual residence.
The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.
Shaomei Chen is a PhD researcher in the Research Program of Limits of Tax Jurisdiction at Leiden University, the Netherlands. She is writing her PhD thesis in Tax Treaties. Shaomei completed her Adv. LL.M. in International Tax Law with summa cum laude at International Tax Center of Leiden University. After that, she served as teaching assistant in 2016 fall term. She currently is also a guest lecturer at International Tax Center Leiden, lecturing some Tax Treaties courses for ITC Leiden South-East Asia Program in International Tax Law at Jakarta, Indonesia and ITC Leiden Summer Course at Shanghai, China. She is awarded with fully-funded scholarships by China Scholarship Council for her Adv. LL.M and her PhD research at Leiden.
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