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OECD Model Tax Convention
The OECD Model Tax Convention is the basis on which all tax treaties are negotiated and implemented by the OECD countries. It is a model agreement to which an accompanying Commentary is provided as an aid to interpretation.
Below is some information on certain key articles of the Model Convention.
Articles 1 and 2 of the convention identify the persons covered by the tax treaty and the taxes covered.
- Persons include not only individuals but also companies, trusts and partnerships. To qualify for the benefits of a tax treaty, a person must be resident in one of the contracting states, and liable to tax in at least one of the states.
Article 3 provides general definitions.
- To the extent that a term is not defined in the tax treaty itself, then the "gap" is filled by the domestic laws of the contracting states.
Article 4 defines residence.
- A person must be a resident of a contracting state in order to have a basis for qualifying for treaty benefits. Article 4 also resolves dual residence problems (which can otherwise lead to double taxation).
Article 5 defines the concept of a Permanent Establishment (or "PE").
- This is a key article as the presence of a PE in one state (the "source state) maintained by a resident of the other contracting state (typically a company) will give the "source" state taxing rights which it would not otherwise have under the tax treaty in the absence of a PE.
Article 7 defines "business profits".
- If a resident of one of the contracting states generates business profits from the territory of the other (source) state, then these profits will be protected from tax in the source state provided that the trader does not have a PE (see article 5, referred to immediately above) to which these profits are attributable in the source state.
- Such profits are said to be "treaty protected".
Article 9 contains transfer pricing provisions.
- Article 9(1) permits a contracting state to adjust the profits of a local enterprise where they arise as a result of "conditions made or imposed with an associated enterprise in the other state which differ from those that would have been made between independent enterprises".
- Article 9(2) permits the other state i.e. the state not involved in the transfer pricing adjustment, to make "an appropriate adjustment" often referred to as a "corresponding" adjustment. But there is no requirement for the other state to do this, which can lead to double taxation.
Articles 10, 11 and 12 - these are the so called "investment articles" i.e. the dividend, interest and royalty articles.
- These three articles reduce the impact of source withholding taxes on recipients of such income in the "residence" state.
- In the case of dividends, the reduced rates of withholding tax fall to 5% where a company in the residence state holds at least 25% of the capital of the dividend paying company in the source state. In practice, i.e. in "live" tax treaties based on the Model, the reduced treaty rate is sometimes 0%.
- All 3 articles contain anti-treaty-shopping provisions, and the interest and royalty articles also contain transfer-pricing provisions.
Article 13 is the capital gains article.
- In the context of international tax planning it is significant that gains realised by a treaty-protected holding company from the sale of shares in a subsidiary company located in the other (source) contracting state will often be exempted from tax in the source state and exclusive taxing rights will be given by the tax treaty to the residence state (state of the holding company).
- If such gains are received by, for example a UK, or Hong Kong or Cyprus company in these circumstances, no corporation tax may be payable on these "treaty protected" gains in the residence state, (see e.g. the UK's "substantial shareholder exemption, or the Cyprus and Hong Kong territorial exemptions).
Articles 23A and 23B: relief from double taxation.
- The prime function (often overlooked by the OECD in its quest for ever-greater exchange of information) of a double taxation convention is to prevent double taxation. There are two methodologies by which double taxation burdens may be relieved, the "exemption" method (article 23A) and the "credit" method (article 23B).
- States vary in their use of either method and this simply reflects the rules of different domestic tax systems. States often use a combination of both methods.
- In the UK for example dividends received by UK companies from foreign subsidiaries are liable to UK corporation tax (and therefore double tax relief would be by way of credit) unless the dividend comes within the exemption rules (exemption method). In practice, most foreign dividends received by UK companies are now subject to exemption from UK corporation tax.
Article 26 is the exchange of information article.
- This deals with exchanges of information between the authorities of the contracting states for the prevention of evasion of taxes.
- Generally the taxes covered by the exchange of information article are not only those stated in article 2, but other taxes as well.
- There is a requirement of confidentiality on the tax authorities in their exchange of information, particularly in relation to commercially sensitive information.
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