By Shaomei Chen
In the application of a tax treaty based on the OECD Model Convention (2014), dual residence of companies is addressed in Art. 4(3) that deems the company to be a resident only of the State in which its place of effective management (PoEM) is situated:
“3. Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident only of the State in which its place of effective management is situated.”
As observed by the OECD Commentary (Paragraph 21 on Art. 4), a company may be a dual resident if it is incorporated in a state but is effectively managed in another state, which is not uncommon in practice. In that case, according to Art. 4(3) of the 2014 OECD MC, the company is resident only of the latter state for the purpose of the tax treaty concluded between these two states. However, the application of the PoEM criterion is not always easy given that no explicit interpretation of “place of effective management” is provided by the OECD MC and various domestic meanings may be referred to in interpreting the phrase. For instance, some countries, like the UK, consider the place where the board of directors hold the meetings relevant for determining the PoEM, while some countries may contend that the PoEM of the company should be the place where the top-level executives carry on their management activities.
In the 2017 draft update of the OECD MC, the PoEM criterion is replaced by a cases-by-case approach (or the MAP tie-breaker rule), as a result of the adoption of the report of BEPS Action 2. The new Art. 4(3) is as followed:
“3. Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, the competent authorities of the Contracting States shall endeavor to determine by mutual agreement the Contracting State of which such person shall be deemed to be a resident for the purpose of the Convention, having regard to its place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors. In the absence of such agreement, such person shall not be entitled to any relief or exemption from tax provided by this Convention except to the extent and in such manner as may be agreed upon by the competent authorities of the Contracting States.”
Before the launch of BEPS Action Plan, identical provision had already existed in the OECD Commentary since 2008 as an alternative provision to the PoEM tie-breaker rule and had been adopted in some existing treaties (e.g. the Netherlands-US Income Tax Treaty (1992) and the Netherlands-UK Income Tax Treaty (2008)). Under the case-by-case approach, dual residence of companies is dealt with by mutual agreement, which is achieved by the two residence states involved, having regard to the company’s place of effective management, place of incorporation and other factors. The adoption of a subjective approach seems to have resolved problems of the PoEM criterion, but in fact it will create other problems in terms of certainty and effectiveness.
It is important to note that Art. 4(3) OECD MC (2017) uses the wording of “shall endeavor to” instead of “shall” as contained in Art. 4(2)(d) dealing with dual resident individuals, indicating that the competent authorities are not obliged to reach an agreement to resolve the dual residence issue under the 2017 rule. The competent authorities of the treaty parties in general will not have initiative to reach an agreement, as it will result in one of the two countries losing its status of the residence state of the taxpayer for the purpose of the treaty. In addition, there is no explicit reference to Art. 25 which specifies mutual agreement procedure (MAP) in the new Art. 4(3), and therefore, it is not clear whether the compulsory arbitration in Art. 25(5) would be applicable when the two treaty parties are unable to reach an agreement. In fact, the Explanatory Statement of the MLI has dismissed the applicability of Art. 25(5) in such cases by the reason that double taxation incurred by dual residence cannot be considered not in accordance with the provisions of the tax treaty – which is a condition required in Art. 25(5). It is because the new Art. 4(3) has explicitly specified the consequence in the absence of a mutual agreement, denying the dual resident’s entitlement to “any relief or exemption from tax provided by this Convention”. Without the compulsory arbitration, dual residence of companies may not be resolved under the case-by-case approach.
Even if an agreement can be concluded, it may take substantial time to finally complete a MAP. From the statistics released by the OECD member countries, the average time for the completion of MAP cases by two OECD member countries is 20.47 months in the 2015 reporting period. Before an agreement is concluded, the company is resident of both states for treaty purpose and may be liable to tax on its world-wide income in both states without any unilateral relief or treaty relief. Although the agreement is understood as having a retroactive effect, which deems the company not to be resident of the loser state for the tax years at issue, practical problem on whether the company can reclaim the tax paid on a residence basis in the loser state may arise given the time limits provided in the domestic laws. Also, the company will suffer a cash-flow loss related to the time value of money, even if it can reclaim the tax.
As emphasized above, the new Art. 4(3) provides that the dual resident company “shall not be entitled to any relief or exemption from tax provided by this Convention except to the extent and in such manner as may be agreed upon by the competent authorities of the Contracting States” in the absence of a mutual agreement. It means that benefits provided by the distributive rules (Art. 6 to Art. 22) and the relief article (Art. 23A or B) are not available to the company without the settlement of dual residence. However, this would not prevent the company from being considered a resident of each Contracting State for purposes other than being granted relief or exemption from tax. For instance, it would still be a resident of both states for purpose of exchange of information under Art. 26 and for purpose of determining the residence status of the distributing company paying the dividend under Art. 10 and also of the person paying the interest under Art. 11. The Commentary on the 2017 update to the OECD MC (see paragraph 24.4 on Art. 4) has confirmed such interpretation. It seems to suggest that the new Art. 4(3) cannot apply to resolve the dual residence in the situations where the payer or other persons as referred to in a relevant distributive rule, rather than the taxpayer, is considered a resident of both Contracting States.
If this logic is followed, assume that a taxpayer of State R derives dividends distributed by a company which is considered to be resident of both State S and State R, as it is incorporated in State S but effectively managed in State R. In applying Art. 10 of the treaty between State R and State S that follows the 2017 OECD MC in respect of the dividends payment, the distributing company will remain a resident of each state, with or without the mutual agreement settling the dual residence. In such case, it is not clear whether the geographical condition in Art. 10(1) that requires the dividends received by a resident of State R being paid by a company which is a resident of the other Contracting State, i.e. State S, is met. In my view, since the distributing company is confirmed to be resident of each state for purpose of applying Art. 10, the dividends at issue are indeed paid by a resident company of State S, and consequently, the geographical condition in Art. 10(1) should be considered to have satisfied. However, this would raise a problem. State R may be obliged to grant treaty relief for the tax levied by State S on the dividends pursuant to Art. 23, given that the tax levied by State S is in accordance with provisions (Art. 10) of the treaty. Such consequence may not be equitable particularly if a mutual agreement for dual residence of the distributing company is reached by the competent authorities, and State S is concluded to be the loser state. From State R’s perspective, the dividends at issue involve purely domestic transaction, and its taxation on the dividends should not be affected by the treaty provisions.
An alternative interpretation is that the new Art. 4(3) can apply to resolve the dual residence in the situations where the payer or other persons as referred to in a relevant distributive rule, rather than the taxpayer, is considered a resident of both Contracting States, but in the absence of a mutual agreement, the payer or other persons, rather than the taxpayer, remain resident of each Contracting State. It means that once an agreement is reached, the conclusion of the agreement should be taken into account in determining whether the payer is resident of “the other Contracting State”. In the above case, if the agreement has concluded that State S is the loser state for the residence of the distributing company, the dividends cannot be considered to have been paid by a resident of State S, and therefore Art. 10 fails to apply. Unless the dividends are effectively connected with a permanent establishment in State S of the taxpayer, State S would be prohibited from taxing the dividends. Any tax that have been paid by the taxpayer to State S should be reclaimed. This interpretation is more appropriate in terms of equity and certainty, but it may entail some practical problems, for instance, on whom should request the mutual agreement procedure. Though it is the payer that is considered to be a dual resident, it may not have the initiative to request for a MAP since it is not liable to tax in respect of the dividends payment. While the dividends recipient has substantial interest, it is not clear whether it would have rights to request a MAP to resolve dual residence issue associated to a different person.
From above, it seems that the MAP tie-breaker rule would result in further uncertainty and burdensome administrative work, compared to the PoEM criterion. As indicated in the Commentary of the 2017 update to the OECD MC (paragraph 23 on Art. 4), the rationale to adopt the rule seems to dissuade the companies from abusing the dual residence status of companies to obtain relief or exemption from tax by provisions of the treaty. It can explain why the new Art. 4(3) explicitly states that the company is not entitled to any benefits from the treaty in the absence of a mutual agreement. But this is probably overkilling given that no distinction is made between the bona fide dual resident companies and those with tax avoidance intention. Further, in the situations where there is no mutual agreement, the company at issue is resident of both states for the purpose of the treaty between those two states and therefore, it would still have entitlement to benefits provided by two set of tax treaties of each residence state, and there would not be any issue with respect to the second sentence of Art. 4(1) of the treaties of the loser state (as there is no “loser state”). In such case, the company may still benefit from the dual residence triangular structure. Issue on the MAP tie-breaker rule involving dual residence triangular structure will be further discussed in next post. With these problems, it remains to be seen whether the case-by-case approach would be accepted by the countries and how the problems would be resolved in the future.
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.
The Impact of the Advance Transfer Pricing Agreements on Voluntary Compliance Tax administrations are required to help minimize the tax risks that affect the reduction on tax revenues. On the other hand, any tax administration should seek to encourage taxpayers voluntary compliance.Read more