UN Model vs OECD Model Treaty: Key Differences in Taxation for Developing Countries

FULL QUESTION

The UN Model Treaty was developed with the developing countries’ intentions and benefits more in mind compared to the OECD Model Treaty. In terms of their contents, what are the specific differences?

ADDITIONAL WRITTEN ANSWER

The key distinction between the UN Model Convention and the OECD Model Convention lies in the approach to taxation, which stems from the differing interests of developed and developing nations. The OECD Model primarily favors residence-based taxation, reflecting the priorities of developed countries, which often have significant multinational enterprises (MNEs) and seek to tax income where the enterprise is resident. In contrast, the UN Model focuses on source-based taxation, aligning more with the needs of developing countries, which want to tax income generated within their borders by foreign enterprises. This focus allows these countries to benefit from the activities of non-resident companies operating locally.

Here are specific differences between the two models:

1. Permanent Establishment (PE) Definition and Threshold:

• UN Model: Expands the definition of a permanent establishment (PE), lowering the threshold for foreign enterprises to be considered as having a taxable presence in the source country. This allows source countries greater opportunities to tax the profits of foreign companies. For example, the UN Model includes a “service PE” clause that allows the source country to tax services performed within its territory, even if no fixed place of business exists.
• OECD Model: The PE definition is more restrictive, focusing on activities carried out through a fixed place of business. It limits taxing rights in the source country, favoring the residence country of the multinational.

2. Taxation of Business Profits:

• UN Model: Grants source countries greater taxing rights over business profits, even when the activities of the non-resident enterprise are not substantial. For example, it allows the taxation of profits that arise from a PE in the source country, with broader definitions of what constitutes a PE.
• OECD Model: Provides a more limited ability for source countries to tax business profits, especially if the enterprise does not meet the stricter PE definition. This tends to benefit the residence country, where the enterprise is headquartered.

3. Taxation of Dividends, Interest, and Royalties:

• UN Model: Source countries are given the right to impose higher withholding taxes on dividends, interest, and royalties. This ensures that developing countries can tax payments made to foreign investors, such as royalties for the use of intellectual property.
• OECD Model: Restricts the source country’s ability to impose withholding taxes on dividends, interest, and royalties. Lower or zero withholding tax rates are often encouraged, benefiting the residence countries, which are usually the home of the investor or patent holder.

4. Capital Gains:

• UN Model: Provides broader taxing rights to the source country, especially regarding gains from the sale of shares or interests in local businesses, real property, or other significant investments.
• OECD Model: Typically limits the taxing rights of the source country to gains arising from real property or local PEs, benefiting the residence country of the investor.

5. Fees for Technical Services:

• UN Model: Includes a specific article that allows the source country to tax fees paid for technical services, management, or consultancy fees rendered within its territory. This is particularly relevant for developing countries that import these services from more advanced economies.
• OECD Model: Does not have a similar provision. This limits the ability of the source country to tax such fees, as they are often considered to be taxed only in the residence country.

6. Dispute Resolution (Mutual Agreement Procedure – MAP):

• UN Model: Lacks a mandatory arbitration clause for resolving disputes between contracting states, which might result in unresolved issues between developed and developing nations. Many developing countries prefer flexibility and control in tax disputes.
• OECD Model: Includes a mandatory arbitration clause, ensuring that disputes, if unresolved by negotiation, will be arbitrated by a third party. This is more in line with the interests of developed countries seeking certainty and efficiency in dispute resolution.

7. Transfer Pricing and Anti-Avoidance Measures:

• UN Model: Developing countries under the UN Model may adopt stricter transfer pricing provisions and anti-avoidance rules to protect their tax base from profit shifting by MNEs.
• OECD Model: While OECD countries follow the OECD Transfer Pricing Guidelines, which aim for a balanced approach, they are generally more aligned with residence-based principles that sometimes limit the source country’s taxing power.

Adoption of the UN Model in Africa: EXAMPLES

Most developing countries, particularly in Africa, prefer the UN Model due to its source-based taxation, which provides more control over taxing foreign enterprises. Some African countries that have adopted or use the UN Model Convention include:

• Kenya: Actively uses the UN Model to maintain taxing rights over foreign companies, especially those involved in natural resource extraction.
• Botswana: Uses the UN Model to preserve its right to tax foreign enterprises engaged in the mining sector and other industries that are critical to its economy.
• Zambia: The UN Model allows Zambia to levy withholding taxes on cross-border payments like interest and royalties, ensuring that foreign investors contribute to local tax revenues.
• Namibia: Adopts the UN Model to secure taxing rights over foreign companies, particularly in its growing sectors like manufacturing and services.