Can you give examples where domestic tax rules override the UN and OECD Model Treaties?


  • QUESTION POSTED BY: Student
  • PROGRAMME: Postgraduate Diploma in International Taxation
  • TOPIC: Introduction to International Taxation (WEEKS 1 & 2)
  • LECTURER: Dr Daniel N Erasmus

FULL QUESTION

The UN Model Treaty was developed with the developing countries’ intentions and benefits more in mind compared to the OECD Model Treaty. Please give specific examples of cases where the domestic tax rule still overrides the two treaties.

ADDITIONAL WRITTEN ANSWER

The United Nations (UN) Model Double Taxation Convention between Developed and Developing Countries and the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention on Income and on Capital both serve as frameworks for bilateral tax treaties. However, they have different emphases, reflecting their target audiences’ interests. The UN Model typically provides more favourable provisions for developing countries, often by allocating more taxing rights to the source countries (where the income arises), which are often developing countries, as opposed to the residence countries (where the income recipient is based), which are often developed.

Despite the international scope and intentions behind these model treaties, domestic tax rules of individual countries can and sometimes do override the provisions of tax treaties derived from either model. Here are some specific examples and general circumstances where domestic tax rules might override these international treaties:

Controlled Foreign Corporation (CFC) Rules

Both the UN and OECD models do not address the specifics of Controlled Foreign Corporation rules, which many countries use to combat tax avoidance through the shifting of profits to low-tax jurisdictions. These rules typically allow a country to tax the income of a foreign subsidiary if the parent company is resident in the country and controls the foreign entity, regardless of whether the profits of the foreign subsidiary have been repatriated.

General Anti-Avoidance Rules (GAAR)

Many countries have implemented General Anti-Avoidance Rules in their domestic tax laws. These rules are designed to counteract aggressive tax planning and schemes that are intended primarily to avoid tax. If a transaction or series of transactions are primarily designed for tax avoidance and have no substantial economic effect, GAAR can be applied to disregard the tax benefit, regardless of any treaty provisions.

Thin Capitalization Rules

These rules restrict the ability of companies to deduct interest on debt from related parties to reduce their taxable income, a practice that can be used to shift profits out of higher-tax jurisdictions. While the OECD guidelines discuss these rules, not all treaty models fully integrate them, and they are generally governed by domestic legislation.

Permanent Establishment (PE) Definitions

While both the UN and OECD model treaties define what constitutes a PE, individual countries often have their own definitions in their domestic tax laws that can be stricter. For example, a country might define a PE in a way that is broader than the treaty definition to capture more foreign enterprises under its taxable presence criteria.

Specific Anti-Abuse Provisions in Domestic Laws

Countries may enact specific legislative measures that target particular areas of concern within their tax systems, such as rules targeting hybrid mismatch arrangements, tax havens, or other specific forms of tax avoidance strategies that are not comprehensively dealt with under the treaty frameworks.

Diverted Profits Tax

Some countries have introduced a Diverted Profits Tax (DPT), aimed at companies that divert profits from the country to avoid taxation. The UK’s DPT, for example, targets large multinational enterprises that use aggressive tax planning techniques to reduce their UK tax liability. This is an example where domestic law specifically targets scenarios not explicitly covered by double tax treaties.

In all these examples, while treaties generally have provisions to prevent or mitigate double taxation and provide a framework for cooperation between tax authorities, domestic laws take precedence when they specifically address scenarios not covered by treaties or when there is a deliberate legislative intent to override treaty provisions to protect the domestic tax base.