Moreover, the Luxembourg-Swiss DTAA provides that in the case of a PE in a Contracting State, the Resident State (State R) will relieve double taxation by using the exemption method (and not the tax credit method as is generally prevalent in the Indian tax treaties), i.e., the Resident State (State R) would not tax the profits attributable to a PE in the other State. Therefore, the profits attributable to the Swiss branch of A Co would be exempt from tax in Luxembourg.
This would result in the interest being taxed in the country of source (with a deduction for the interest paid in the hands of the payer in the country of source) at a concessional treaty rate, very low tax in the country where the PE is constituted, i.e., Switzerland and no tax in the country of residence, i.e., Luxembourg by virtue of the exemption method followed in the Luxembourg-Swiss DTAA.
Like interest, one could also transfer other assets which resulted in passive income such as shares and intangible assets, resulting in a low tax incidence on the dividend and royalty income, respectively.
Let’s take the example of India, where a resident of Luxembourg invests in the shares of an Indian company through a PE situated in Switzerland. In such a scenario, India would tax the dividend at the rate of 10% due to the India-Luxembourg DTAA (as against 20% under the Act), Switzerland may tax the income attributable to the PE at a low rate and Luxembourg would not tax the income in accordance with the Luxembourg-Switzerland DTAA.
The OECD, recognising the use of PE to artificially apply lower tax rates, attempted to tackle this in the OECD Model Convention by providing further guidance on what would be considered as income effectively connected in the PE. For example, para 32 of the 2014 OECD Model Commentary on Article 10, dealing with taxation of dividends, provides,
‘It has been suggested that the paragraph could give rise to abuses through the transfer of shares to permanent establishments set up solely for that purpose in countries that offer preferential treatment to dividend income. Apart from the fact that such abusive transactions might trigger the application of domestic anti-abuse rules, it must be recognised that a particular location can only constitute a permanent establishment if a business is carried on therein and, as explained below, that the requirement that a shareholding be “effectively connected” to such a location requires more than merely recording the shareholding in the books of the permanent establishment for accounting purposes.’
Similar provisions were also provided in the Commentary on Article 11 and Article 12, dealing with interest and royalty, respectively.
However, the above provisions may not necessarily always tackle all forms of tax avoidance. Thanks to the nature of tax treaties applying only in bilateral situations, it may not apply in case of a PE constituted in a third state (State PE). Similarly, one may still achieve an overall low rate of tax by moving the functions related to the activities in the State PE. For example, in the case of a finance branch, one can consider moving the treasury team to State PE with an office, which would constitute a fixed place of business and therefore, the interest income earned from the group financing activities may still be effectively connected to the PE in the State PE.
The OECD Model recognised this limitation and para 71 of the 2014 OECD Model Commentary on Article 24 provides that a provision can be included in the bilateral treaty between the State R and the State S to provide that an enterprise can claim the benefits of the treaty only if the income obtained by the PE situated in the other State is taxed normally in the State of the PE.
1.3 BEPS Action 6
The US was one of the few countries which had provisions similar to the Article in the MLI in its tax treaties even before the OECD BEPS Project. In fact, even though the US is not a signatory to the MLI, the provisions as released by the US were used as a base for further discussion in the BEPS Project. The anti-abuse rule was covered in the OECD BEPS Action Plan 6 dealing with Preventing the Granting of Treaty Benefits in Inappropriate Circumstances.
The objective of the anti-abuse provision is provided in para 51 of the BEPS Action 6 report, which is reproduced below,
‘It was concluded that a specific anti-abuse provision should be included in the Model Tax Convention to deal with that and similar triangular cases where income attributable to the permanent establishment in a third State is subject to low taxation.’
While the language in the MLI is similar to the suggested draft in the final report of the BEPS Action Plan 6, there are certain differences – mainly certain deletions, in the MLI, which have been discussed in detail in the second part of this article.
It is important to note that while Article 10(1) is included in the MLI as a specific anti-avoidance rule, MLI also contains a general anti-avoidance rule under Article 7 through the PPT. Further, in the Indian context, the domestic law also contains anti-avoidance provisions in the form of general anti-avoidance rules. An interplay between all three is discussed in para 3.5 below.
2. STRUCTURE AND LANGUAGE OF ARTICLE 1
2.1 Introduction to Article 10
The language contained in this Article refers to various terminologies that have been defined under Article 2 of the MLI [e.g., Contracting Jurisdiction (‘CJ’), Covered Tax Agreement (‘CTA’)]. Those terminologies referred to in Article 10, which have not been defined under Article 2 of the MLI, have to be interpreted as per Action 6 of Base Erosion and Profit Shifting (‘BEPS’).
Article 10 of the MLI seeks to deny treaty benefits in certain circumstances.
2.2 Structure
Article 10 of the MLI is structured in six paragraphs wherein each paragraph addresses a different aspect related to the anti-abuse provision. The flow of the Article is structured in such a way that the conditions for attracting the provisions of the article are laid down first, followed by the exceptions and finally the reservation and notification which are in line with the overall scheme of the MLI.
To better understand Article 10, it would be beneficial to understand each paragraph individually. Let us proceed as per the order of the article.
Paragraph 1:
Paragraph 1 brings out the conditions for the applicability of Article 10 in certain circumstances:
‘Where:
a) an enterprise of a Contracting Jurisdiction to a Covered Tax Agreement derives income from the other Contracting Jurisdiction and the first-mentioned Contracting Jurisdiction treats such income as attributable to a permanent establishment of the enterprise situated in a third jurisdiction; and
b) the profits attributable to that permanent establishment are exempt from tax in the first-mentioned Contracting Jurisdiction,
the benefits of the Covered Tax Agreement shall not apply to any item of income on which the tax in the third jurisdiction is less than 60 per cent of the tax that would be imposed in the first-mentioned Contracting Jurisdiction on that item of income if that permanent establishment were situated in the first-mentioned Contracting Jurisdiction. In such a case, any income to which the provisions of this Paragraph apply shall remain taxable according to the domestic law of the other Contracting Jurisdiction, notwithstanding any other provisions of the Covered Tax Agreement.’
Each underlined word is a condition for the applicability of the article and has its own significance.
An enterprise – The question as to how to interpret the term ‘an enterprise’ and what comes under the purview of the same is covered in the later part of this article.
derives income from the other Contracting Jurisdiction – This emphasises on the aspect that the income earned by the Resident State should be derived from the State S for the Article to get triggered.
income as attributable to a permanent establishment of the enterprise situated in a third jurisdiction – In addition to the condition as mentioned above, the income derived by the State PE from State S should be treated as attributable to the PE in State PE by State R.
exempt from tax in the first-mentioned Contracting Jurisdiction – This covers the point regarding the taxability of the profits attributable to the PE in the State R. It focuses on the point that Article 10 would be applicable if the profits attributable to the PE are exempt from tax in State R.
tax in the third jurisdiction is less than 60 per cent – This sentence points out the 60% test which states that the tax in the State PE is less than 60% of the tax that would be payable in the State R on that item of income if that PE was situated in the State R.
In case all the above conditions are satisfied, the benefits of the CTA between the State R and the State S shall not apply to such item of income.
The second part of paragraph 1 gives power to the State S to tax the item of income as per its domestic laws notwithstanding any other provisions of the CTA in cases where the provisions of Article 10(1) are satisfied.
Thus, it can be understood that the provisions of Article 10(1) emphasise on the denial of treaty benefits in order to prevent complete non-taxation or lower taxation of an item of income.
Paragraph 2:
Paragraph 2 states the exceptions where the provisions as set out in paragraph 1 of the Article 10 will not be applicable.
The exception covers the income derived from the State S in connection with or is incidental to active conduct of the business carried on by the PE. However, the business of making, managing or simply holding investments for the enterprise’s own account such as activities of banking carried on by banks, insurance activities carried on by insurance enterprises and securities activities carried on by registered securities dealers will not come under the purview of paragraph 1 of the Article. The business of making, managing or simply holding investments for the enterprise’s own account carried on by other than the above-mentioned enterprises shall come under the purview of paragraph 1 of the Article. A detailed discussion on what is considered as active conduct of business is covered in the second part of this article.
Paragraph 3:
Paragraph 3 of Article 10 provides that even if treaty relief is denied due to the trigger of the provisions of
Article 10(1), the competent authority of State S has the authority to grant the treaty relief as a response to a request by the taxpayer in the State R on the basis of justified reasons for not satisfying the requirements of Article 10(1).
In such situations, the competent authority of the State S shall consult with the competent authority of the State R before arriving at a decision.
Paragraph 4:
Paragraph 4 is the compatibility clause between paragraph 1 through paragraph 3 which mentions ‘in place of or in the absence of’.
This means that if there is an existing provision in a CTA which denies / limits treaty relief in instances of triangular cases (‘Existing Provision’), then such a provision would be modified (i.e. in place of) to the extent paragraph 1 through 3 are inconsistent with the existing provisions (subject to notification requirements analysed below).
However, if there is no existing provision then paragraph 1 through 3 would be added to the CTAs (i.e., in absence of).
Paragraph 5:
Article 10(5) covers the reservation aspect to be in line with the overall scheme of the MLI.
This reservation clause is applicable because Article 10 is not covered under minimum standard and hence the scope for reservation is wide. There are three options available to each signatory:
a) Article to not be applicable to all CTA’s in entirety, or
b) Article to not be applicable in case where the CTA already contains the provision as mentioned in paragraph 4, or
c) Article to only be applicable in case of CTA’s that already contain the provisions as mentioned under paragraph 4 (i.e., the existing provisions to be modified to the extent that they are inconsistent with the provisions of Article 10).
Paragraph 6:
Article 10(6) provides the notification mechanism to assess the impact of the reservations and position adopted by the signatories on the provisions of the CTAs.
In cases where the parties decide to go as per sub-paragraph (a) or (b) of Article 10(5), then they need to notify the depository whether each of its CTA contains the provisions as per Article 10(4) along with the article and paragraph number. In case where all contracting jurisdictions have made such a notification, then the existing provisions shall be replaced by the provisions of Article 10. In other cases, such as in the case of a notification mismatch (i.e., one signatory to the CTA does not notify the provisions of Article 10 whereas the other signatory to the same CTA notifies them), the existing provisions shall ONLY be modified to the extent that they are inconsistent with the provisions of Article 10.
India has not made any reservation. Further, India has not notified any DTAAs which have a provision similar to that in para 4 of Article 10. Therefore, the provisions of Article 10 of the MLI shall supersede the existing provisions of the DTAAs to the extent they are incompatible with the existing provisions.
2.3 Reason as to why the Source Country should not grant DTAA benefits
The main policy consideration for implementation of Article 10 of the MLI is to plug the structure wherein one can artificially reduce the overall tax simply by interposing a PE in a low-tax jurisdiction, which is a major BEPS concern.
Tax treaties allocate the taxing rights between the jurisdictions. A Source State giving up its taxing rights is a result of bilateral negotiation with the Residence State. However, if such Residence State decides to treat such income as attributable to a third state and therefore not taxing such income by virtue of another treaty of which the Source State is a not a party, would be against the intention of the countries who have negotiated the treaty in good faith.
Therefore, if State R gives up its right of taxation of income earned from State S due to the artificial imposition of a PE in a third State, Article 10 of the MLI gives the entire taxing right back to State S.
3. SOME ISSUES RELATED TO INTERPRETATION OF PARA 1 OF ARTICLE 10 OF MLI
Having analysed the broad provisions of Article 10 of the MLI, the ensuing paragraphs seek to raise (and analyse) some of the issues in relation to para 1 of Article 10.
3.1 Definition of PE – Which DTAA to Apply
While considering the situation of denial of treaty benefits laid out in the treaty between State R and State S with regard to the income earned by the PE of an entity of the State R in a State PE, there are two DTAA’s that come under this purview, namely:
i. Treaty between the State R and the State S, and
ii. Treaty between the State R and the third state (PE State).
For the purpose of referring to the definition of PE, the first question that arises is which of the two DTAAs has to be referred to? This issue arises mainly because the term ‘Permanent Establishment’ is not a general term but is a specific term which is defined in the DTAA (generally in Article 5 of the relevant DTAA).
A view could be that since the acceptability or denial of benefits under the DTAA between the State R and State S is evaluated and State S is the jurisdiction denying the treaty benefit, one should look at the DTAA between the State R and State S to determine the PE status. However, the objective of the anti-abuse provision is to target transactions wherein income is not taxed in State R due to a PE in State PE. Further, MLI 10(1) applies only if the Residence State treats the income of an enterprise derived from the Source State as attributable to the PE of a third State. This decision of Residence State is obviously on the basis of its treaty with the PE State as it is a bilateral decision. As the Source State is not a party to this decision, the treaty between Residence State and Source State cannot be applied. Therefore, a better view would be to consider the provisions of the DTAA between the State R and the third state (State PE) for the definition of PE.
It is also important to note that prior to introduction of MLI, Article 5 of the DTAA was referred to in order to establish the PE status. However, post introduction of the MLI, one would also need to evaluate the impact of Article 12 to Article 15 of the MLI which covers the PE status based on Action 7 of Base Erosion and Profit Shifting (BEPS). This, of course, is subject to the CTA between Residence State and PE State not reserving the above articles.
3.2 Whether PE jurisdiction needs to be a signatory to MLI
Article 10 of the MLI merely provides that State S should deny benefit of the DTAA between State R and State S if certain conditions are triggered. One of the conditions is that the income is treated by Residence State as attributable to the PE of the taxpayer in State PE. Having concluded the above, that the PE definition under the DTAA between State R and State PE should be considered, it is not necessary that such DTAA is impacted by the MLI. If the DTAA between State R and State PE is impacted by the MLI, one would need to consider the modified definition of PE in such a situation.
Here, it would be important to look at Article 34 of the Vienna Convention on the Law of Treaties, 1969. The same is reproduced below:
Article 34 – General Rule Regarding Third States
A treaty does not create either obligations or rights for a third state without its consent.
In this particular scenario, it is clear that there is no right or obligation granted to the State PE under the DTAA between State R and State S. State PE can continue to tax the profits of the PE.
Further, by signing MLI Article 10, State S and State R should be deemed to have consented their rights and obligations under the State R-State S treaty as amended by MLI Article 10. Consequently, State PE would not be required to be a signatory to the MLI.
3.3 No taxation in country of residence
Another issue which arises is what if the country of residence does not tax the income irrespective of whether the income is attributable to a PE or not. For example, if dividend income is earned by a resident of Singapore and such income is attributable to the PE of the shareholder in a third jurisdiction, such dividend would not be taxable irrespective of whether the dividend is attributable to a PE in a third state or not.
In such a scenario, Article 10 of the MLI should not apply as the tax rate in State PE is not less than 60% of the tax rate in State R. In any case, as the Source State had given up its right of taxation even when the Residence State did not tax such income and imposing a third jurisdiction in the transaction, would not result in a reduction of taxes in the Residence State.
3.4 Interplay of Article 10 with Article 5
Article 5 of the MLI provides for the elimination of double taxation using the credit method as against the exemption method. It refers to three options for preventing double non-taxation situations arising due to the State R providing relief under the exemption method for income not taxed in the State S.
The interplay between Article 5 and Article 10 comes into play because Article 10 is applicable only in cases where the income is exempt in the State R. So, in order to determine whether or not the income is exempt in the State R, Article 5 will have to be referred to. If the DTAA between State R and State PE provides for the exemption method for elimination of double taxation, but State R has opted to apply Article 5 of the MLI, the credit method would apply and in such a situation, in the absence of exemption granted in State R, the provisions of Article 10(1) shall not apply.
India has opted for Option C under Article 5 which allows a country to apply the credit method to all its treaties where the exemption method was applicable earlier. Therefore, with respect to India only credit method will be applicable as a method to eliminate double taxation.
Given that India’s tax treaties apply the credit method for providing relief from double taxation, the situation contemplated under Article 5 may not be relevant in the Indian context.
3.5 Interplay of Article 10 with PPT / GAAR
The Principle Purpose Test (‘PPT’) rule under Article 7 is the minimum standard and applies to all DTAAs covered under MLI. A question could therefore arise as to which provision would override the other. It is pertinent to note that provisions of Article 29 of the OECD Model clearly specify that Article 29 would apply where the PPT has been met. However, Article 10 of the MLI does not lay down any preference of application of PPT or otherwise. Consequently, it could be possible to take a view that if the specific conditions of Article 10 are met, PPT rule should not apply to deny the treaty benefits.
However, a better and sensible view could be that even if the special anti-abuse provision contained in Article 10 is satisfied, the general anti-abuse provision under Article 7(1) also needs to be satisfied to avail treaty benefits. In other words, where the main purpose to set up or constitute the PE in the third state (State PE) was to obtain tax benefit, such an arrangement should be covered under the mandatory provisions of Article 7(1) of the MLI so as to deny the treaty benefits. In a case where the provisions of MLI Article 10 are applicable, the treaty benefits can be denied based on the applicability of MLI Article 10 itself. In other words, MLI article 7(1) and MLI Article 10 both can co-exist and an assessee needs to satisfy both the tests to avail treaty benefits.
Further, in a case where India is the State S, one will also have to see the applicability of GAAR provisions and its interplay with the provisions of Article 10. Typically, GAAR applies where the main purpose of the arrangement is to obtain tax benefit and the GAAR provisions can kick in to deny the treaty benefits as well. Here it is important to note that both Indian domestic law and OECD recognise that the provisions of GAAR / PPT and SAAR / MLI 10 can co-exist. FAQ 1 under Circular 7 of 2017 states that the provisions of GAAR and SAAR can co-exist and are applicable, as may be necessary, in the facts and circumstances of the case. The same has also been recognised under para 2 of the OECD commentary on Article 29.
4. CONCLUSION
In the second part of this article, the authors will attempt to analyse some practical challenges arising on account of the difference in the tax rates of the jurisdictions involved and the impact of the anti-avoidance rule on India. The second part will also cover the difference between Article 10 of the MLI and the BEPS Action Plan 6 Report on the basis of which the rule was incorporated in the MLI and Article 29 of the OECD Model.
