Deciphering International Tax Treaties: A Strategic Guide for Global Enterprises
Author: Meghna Khetrapal & Divyanshi Singh, Aerie Law
Introduction:
With an increase in cross-border business interaction, businesses should deal with intricate compliances and tax-related formalities, internationally.
Double Taxation Avoidance Treaties (DTAs) are bilateral agreements that significantly contribute to harmonizing multitude of international taxes and promoting global commerce. This article focuses on the OECD Model Tax Convention (OECD Model) and the UN Model Double Taxation Convention (UN Model) resolve tax disputes through global solutions. With the development of cross border tax policies, such as the OECD's BEPS project and the global minimum tax, organizations simply need to comply with international treaties.
This article analyses OECD Model, UN Model, implication of international tax treaties, their basic features, and emerging trends to shed light on strategic tax management.
The Foundation of International Tax Treaties:
International tax treaties avoid dual taxation and financial misconduct through the application of models such as the OECD Model and the United Nations Model.
Tax treaties also contain fundamental provisions on dispute settlement and exchange of information. Foundational recourse mechanisms such as Mutual Agreement Procedures (MAP) and arbitration, as stipulated in the OECD Model and UN Model and play a substantial role in resolving disputes.
The OECD Model and UN Model:
The OECD Model and UN Model are the fundamental models for international tax treaties, providing guidelines for countries in bilateral negotiations.
The OECD Model is commonly used by developed nations to address concerns around double taxation and promote cross-border trade by minimizing tax barriers. Conversely, the UN Model focuses on the needs of developing countries, favoring greater taxing rights for source countries, which are typically the host countries of investment. The UN Model also emphasizes on a wider definition of determining a Permanent Establishment.
Despite the difference between the two models, both are rooted in common essentials of the Vienna Convention on the Law of Treaties, whose focal point is good faith interpretation.
Core Provisions of Tax Treaties:
Tax Residency and Permanent Establishment (PE):
The tax liability of a business depends on its residency or place of Permanent Establishment, according to international treaties. The PE clause plays a major role in deciding whether a foreign enterprise would be charged tax in a foreign state. Factors determining PE include the place of business and dependent agent.
Businesses should evaluate their overseas operations to realize PE implications and tax consequences. Strategic decisions in business structures should follow with leg companies or subsidiaries being established in tax friendly jurisdictions, provided adequate compliances are undertaken.
Withholding Tax on Dividends, Interest, and Royalties:
Tax treaties usually reduce withholding tax rates on cross-border payments to reduce excessive taxation to prevent double taxation and encourage international business.
Capital Gains Taxation:
Tax treaties usually specify the nation which may tax capital gains from disposals of assets or follow the general rule that capital gains are usually taxable in the country of the seller’s residence, with some carveouts for real estate and business assets. Assessing these provisions in connection with evolving business structures can guarantee tax effectiveness.
Elimination of Double Taxation:
Tax conventions avoid double taxation by various mechanisms namely:
a) the Exemption Method, which excludes income that is taxed in a foreign nation,
b) the Credit Method, which permits tax credits against residence country liabilities.
Illustratively, the US Japan Tax Treaty allows residents in United States of America to claim tax credits on taxes paid in Japan.
Emerging Trends in International Tax Treaties:
Principal Purpose Test: The PPT has emerged as an anti- abuse rule to deny treaty benefits if procuring a tax advantage was the only purpose of a transaction. The trend emerged to curb treaty shopping through intermediaries set up in tax friendly jurisdictions.
Digital Economy Taxation: OECD’s Pillar One framework allows taxation of digital companies based on user location and not just physical footprint, after they cross a global revenue of €20 billion and have a profit margin above 10%.
Strengthening source-based taxation: Global minimum tax of 15% imposed for multinational corporations (MNCs) with revenues over €750 million, to prevent profit shifting to low tax jurisdictions, like Ireland.
Tax treaties aim to extend their reach to digital services for gig workers, remote workers and e-commerce companies.
Tax treaties also aim to harmonize with climate goals, thereby providing incentives to certain sectors aligned with climate goals.
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