INTERNATIONAL FISCAL
ASSOCIATION CONFERENCE
MADRID, SPAIN 2016
INTERNATIONAL FISCAL ASSOCIATION
MADRID 2016
Double Taxation and the Structure of Tax Treaties
By Vern Krishna, CM, QC, FRSC
International juridical double taxation is the imposition of comparable taxes in two (or more) States on
the same taxpayer in respect of the same subject matter, and for identical periods. In the simplest
case, State S may tax an entity on income that it earns in the country, while State R taxes the entity on
the same income based on its residence in State R. Double taxation of income harms international
trade, and the exchange of goods, services, movements of capital, and technology. Countries address
double tax problems either through their domestic tax systems, or through their bilateral treaty
networks. The OECD and the International Fiscal Association (IFA) continue to monitor and discuss
treaty structures that can cause double taxation or double non-taxation of income and capital.
However, absent specific treaty provisions, by virtue of a long standing common law doctrine,
countries do not enforce the revenue laws of other countries. Hence, the need for multinational
income and capital tax treaties.
I.
The Revenue Rule
Revenue laws, be they income tax, sales tax or import duties, reflect a sovereign’s political will and
create property rights that affect taxpayers’ relationships with their sovereign. Tax law is legislated
policy that mirrors the political, moral, and social sensibilities of a society.
It is well accepted law that sovereign states will not enforce the revenue laws of foreign countries.
Courts cannot exercise their jurisdiction beyond their national boundaries. The rule, generally known
as the “revenue rule”, is a common law doctrine of long standing that provides that the courts of one
sovereign will not enforce final tax judgments, or unadjudicated tax claims, of other sovereigns.
The rule has a long history. See, for example, Holman v. Johnson, 98 Eng. Rep. 1120, 1121 (K.B. 1775)
(Lord Mansfield) (“For no country ever takes notice of the revenue laws of another.”); Planche v.
Fletcher, 99 Eng. Rep. 164, 165 (K.B. 1779) (Lord Mansfield) (“One nation does not take notice of the
revenue laws of another.”).
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II.
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Rationale of the Revenue Rule
The rule had an economic foundation in eighteenth-century English court decisions seeking to protect
British trade from the oppressiveness of foreign customs. In Boucher v. Lawson, 95 Eng. Rep. 53 (K.B.
1734) (Lord Hardwicke, C.J.), the court acknowledged that its concerns with promoting British trade led
it to uphold a transaction that violated Portuguese export laws. Chief Justice Lord Hardwicke stated
that to do otherwise “would cut off all benefit of such trade from this kingdom, which would be of very
bad consequence to the principal and most beneficial branches of our trade.”
The rule later entered into United States common law, international law, and the national law of other
common law jurisdictions, including Canada. The modern rationale of the revenue rule is that
it respects sovereignty, concern for judicial role and competence, and separation of powers. 1 Lord
Denning explained the rationale in Attorney General of New Zealand v. Ortiz, [1984] A.C. 1 (H.L.) as
follows:
“The class of laws which will be enforced are those laws which are an exercise by the sovereign
government of its sovereign authority over property within its territory or over its subjects wherever
they may be. But other laws will not be enforced. By international law every sovereign state has no
sovereignty beyond its own frontiers. The courts of other countries will not allow it to go beyond the
bounds. They will not enforce any of its laws which purport to exercise sovereignty beyond the limits of
its authority.”
Similarly, in the United States, Judge Learned Hand offered a rationale in support of the rule: 2
“[A] court will not recognize those [liabilities] arising in a foreign state, if they run counter to the
‘settled public policy’ of its own. Thus, a scrutiny of the liability is necessarily always in r eserve, and the
possibility that it will be found not to accord with the policy of the domestic state. . . . No court ought
to undertake an inquiry which it cannot prosecute without determining whether those laws are
consonant with its own notions of what is proper.”
Lord Keith of Avonholm, having approved of the judgment of Kingsmill Moore J. in the High Court of
Eire in Peter Buchanan Ld. & Macharg v. McVey, reported as a note in [1955] A.C. 516, suggested two
explanations for the rule:
“One explanation of the rule thus illustrated may be thought to be that enforcement of a claim for
taxes is but an extension of the sovereign power which imposed the taxes, and that an assertion of
sovereign authority by one State within the territory of another, as distinct from a patrimonial claim by
a foreign sovereign, is (treaty or convention apart) contrary to all concepts of independent
sovereignties.”
A second explanation is that scrutiny of a tax judgement implies a review of the policy underlying the
tax, which would require a review of the policies of another sovereign jurisdiction.
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“This would require the court to rule on the provisions for the public order of another State, which may
commit “the domestic State to a position which would seriously embarrass its neighbour. No court
ought to undertake an inquiry which it cannot prosecute without determining whether those laws are
consonant with its own notions of what is proper.”
III.
Application of the Rule
a.
The United Kingdom
The House of Lords applied the rule in Government of India, Ministry of Finance (Revenue Division)
v. Taylo.r3 At page 504, Viscount Simonds adopted the following from In re Visser, The Queen
of Holland v. Drukker::4
“My own opinion is that there is a well-recognized rule, which has been enforced for at least 200 years
or thereabouts, under which these courts will not collect the taxes of foreign States for the benefit of
the sovereigns of those foreign States; and this is one of those actions which these courts will not
entertain.”
b.
The United States
The United States maintains its general policy on extraterritorial collection assistance, and the
preservation of its sovereignty, security, and public policy. Its 2006 Model Income Tax Convention, for
example, does not contain any general provision assisting or allowing the enforcement of foreign tax
judgments or claims. Instead, Article 26, paragraph 7, of the Convention (“Exchange of Information and
Administrative Assistance”) provides that:
“Each of the Contracting States shall endeavor to collect on behalf of the other Contracting State such
amounts as may be necessary to ensure that relief granted by the Convention from taxation imposed
by that other State does not inure to the benefit of persons not entitled thereto. This paragraph shall
not impose upon either of the Contracting States the obligation to carry out administrative measures
that would be contrary to its sovereignty, security, or public policy.”
The limited assistance offered in Article 26 of the Model Convention is specifically qualified:
“[Paragraph 4] shall not impose upon either of the Contracting States the obligation to carry out
administrative measures that would be contrary to its sovereignty, security, or public policy.”
Consistent with its treaty policy, the United States has a number of tax treaties with foreign sovereigns
that provide for information exchange and, sometimes, limited collection assistance. However, the
treaties do not provide for general enforcement of foreign tax judgments or claims. See, for example,
the Canada-U.S. 1995 Protocol. Prior to 1995, the U.S.-Canada tax convention provided for exchange of
information between the tax authorities of the contracting states, and also for minimal mutual
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collection assistance- limited to that assistance necessary to ensure that the exemptions, reduced rates
or other benefits provided in the treaty would not be enjoyed by persons not entitled to those
benefits.5
However, the 1995 protocol requires that a State seeking collection assistance certify that the revenue
claim has been “finally determined.” A claim is finally determined when the Applicant State has the
right under its internal law to collect the revenue claim and all administrative and judicial rights of the
taxpayer to restrain collection in the Applicant State have lapsed or been exhausted. Thus, the treaty
does not abrogate the rule that courts of one nation should not adjudicate the unresolved tax claims of
another.
In United States v. Boots, 80 F.3d 580 (1st Cir.), cert. denied, 519 U.S. 905, 136 L. Ed. 2d 188, 117 S. Ct.
263 (1996), the First Circuit dismissed an indictment for a cross-border smuggling scheme designed to
avoid Canadian taxes. (at page 587: “For our courts effectively to pass on [foreign revenue] laws raises
issues of foreign relations which are assigned to and better handled by the legislative and executive
branches of government.”), and at 587-88 (“Of particular concern is the principle of noninterference by
the federal courts in the legislative and executive branches’ exercise of their foreign policymaking
powers.”).
For the application of the revenue rule generally, see: Aetna Ins. Co. v. Robertson, 127 Miss. 440, 90 So.
120, 126 (Miss. 1921) (Ethridge, J., dissenting)(“It is a familiar principle of law that one state or country
will not aid another state or country in giving effect to judgments enforcing its penal laws, or in
collecting its revenues.”); Henry v. Sargeant, 13 N.H. 321 (1843) (collecting cases that support the
principle that penal and revenue laws are “strictly local” and are not enforced by foreign states); State
of Colorado v. Harbeck, 232 N.Y. 71, 85, 133 N.E. 357 (1921) (“The rule [of “private international law”]
is universally recognized that the revenue laws of one state have no force in another.”); Williams &
Humbert Ltd. v. W&H Trade Marks (Jersey) Ltd., 1986 1 All E.R. 129, 133-34 (H.L.) (Although the
“revenue laws may in the future be modified by international convention or by the laws of the
European Economic Community[,] . . . at present the international rule with regard to the nonenforcement of revenue and penal laws is absolute.”); Peter Buchanan L.D. v. McVey, [1955] A.C. 516,
524-28 (Ir. H. Ct. 1950) (surveying application of the revenue rule by United Kingdom courts),
aff’d, [1955] A.C. 530 (Ir. S.C. 1951); Government of India v. Taylor, [1955] A. C. 491, 508 (H.L.) (denying
claim of Indian government for unpaid taxes against company in liquidation in Britain because British
courts would not enforce Indian revenue laws, stating “we proceed upon the assumption that ther e is
a rule of the common law that our courts will not regard the revenue laws of other countries: it is
sometimes, not happily perhaps, called a rule of private international law: is at least a rule which is
enforced with the knowledge that in foreign countries the same rule is observed”); see also William S.
Dodge, Antitrust & the Draft Hague Judgments Convention, 32 Law & Pol’y Int’l Bus. 363, 373 n.43
(2001) (discussing the application of the revenue rule in both common law and civil law countries);
Stoel, supra note 2, at 671-74 (discussing the application of the revenue rule in commonwealth
countries).
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See also: Moore v. Mitchell, 30 F.2d 600, 604 (2d Cir. 1929) (L. Hand, J., concurring), aff’d on other
grounds, 281 U.S. 18, 74 L. Ed. 673, 50 S. Ct. 175 (1930). In part, the reluctance of courts to delve into
such matters is based on the “desire to avoid embarrassing another state by scrutinizing its penal and
revenue laws.” Sabbatino, 376 U.S. at 437; see United States v. Boots, 80 F.3d 580, 587 (1st Cir.), cert.
denied, 519 U.S. 905, 136 L. Ed. 2d 188, 117 S. Ct. 263 (1996). Similarly, in Peter Buchanan L.D. v.
McVey, [1955] A.C. 516, 529 (Ir. H. Ct. 1950), aff’d, [1955] A.C. 530 (Ir. S.C. 1951), relied on by the
United States Supreme Court in Sabbatino, 376 U.S. at 437-38, the Irish High Court noted that courts
had traditionally exercised the right to reject foreign law that conflicted with the public policy or
morality of the domestic court, and stated:
“Modern history [is not] without examples of revenue laws used for purposes which would not only
affront the strongest feelings of neighbouring communities but would run counter to their political
aims and vital interests. . . . So long as these possibilities exist it would be equally unwise for the courts
to permit the enforcement of the revenue claims of foreign States or to attempt to discriminate
between those claims which they would and those which they would not enforce. Safety lies only in
universal rejection.”
c.
Canada
Canada applies the revenue rule. In United States of America v. Harnden, for example, the Supreme
Court said: 6
“In my opinion, a foreign State cannot escape the application of this rule, which is one of public policy,
by taking a judgment in its own courts and bringing suit here on that judgment. The claim asserted
remains a claim for taxes. It has not, in our courts, merged in the judgment; enforcement of the
judgment would be enforcement of the tax claim.” (per Cartwright J.)
Notwithstanding the long tradition of the revenue rule, Canada sought to circumvent it in R.J. Reynolds
Tobacco Holdings, Inc. et al. 268 F.3d 103; 2001 U.S. App. LEXIS 21775, by framing its claim in an action
for damages based on lost tax revenue, and additional law enforcement costs, stemming from a
scheme by the defendants to avoid various Canadian cigarette taxes by smuggling cigarettes across the
United States-Canadian border for sale on the Canadian black market. Canada framed its claim under
the Racketeer Influenced and Corrupt Organizations Act (“RICO”), 18 U.S.C. § 1961 et seq., and sought
to recover revenue that it lost “from the evasion of tobacco duties and taxes,” and from “defendants’
conduct that compelled the country to rollback duties and taxes,” as well as monies spent “seeking to
stop the smuggling and catch the wrongdoers.
RICO creates a civil treble damages remedy for any person injured in its business or property by reason
of a violation of the statute. RICO is a broadly worded statute that “has as its purpose the elimination
of the infiltration of organized crime and racketeering into legitimate organizations operating in
interstate commerce.” 7
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In effect, Canada sought to abrogate the revenue rule with respect to claims brought by foreign
sovereigns under RICO. The United States District Court for the Southern District of New York held that
Canada could not use RICO to recover lost tax revenues and enforced the revenue rule stating:
“To the extent that the allegations set forth in Canada’s complaint are correct, we understand
Canada’s frustration that it cannot recoup its lost revenue and law enforcement costs against
defendants that allegedly committed most of their wrongdoing on our side of the common border with
Canada. No court wishes to find itself in the position of being unable to right an alleged wrong.
See Loucks v. Standard Oil Co. of New York, 224 N.Y. 99, 111, 120 N.E. 198 (1918) (Cardozo, J.).
Nonetheless, we are without license to abandon unilaterally the centuries-old, albeit sharply-attacked,
revenue rule. “The hard fact is that sometimes we must make decisions we do not like” because the
laws “compel the result.” Texas v. Johnson, 491 U.S. 397, 420-21, 105 L. Ed. 2d 342, 109 S. Ct. 2533
(1989) (Kennedy, J., concurring). “When and if the [revenue] rule is changed, it is a more proper
function of the policy-making branches of our government to make such a change.” Her Majesty the
Queen in Right of the Province of British Columbia v. Gilbertson, 597 F.2d 1161, 1166 (9th Cir. 1979).
Recourse, to the degree it is warranted and available, lies with the executive and legislature.”
IV.
Exchanges of Information between States
Article 26 of the OECD Model Convention addresses exchanges of information in bilateral treaties
between Contracting States. The article provides for exchanges of relevant information between
States, but the exchanges are subject to certain important safeguards and restrictions.
Article 26
(1)
The competent authorities of the Contracting States shall exchange such information as is
foreseeably relevant for carrying out the provisions of this Convention or to the administration or
enforcement of the domestic laws concerning taxes of every kind and description imposed on behalf of
the Contracting States, or of their political subdivisions or local authorities, insofar as the taxation
thereunder is not contrary to the Convention. The exchange of information is not restricted by Articles
1 and 2. 2.
Paragraph 1 is the principal rule concerning the exchange of information. It requires the competent
authorities of the Contracting States to exchange such information as is foreseeably relevant to secure
the correct application of the provisions of the Convention, or of the domestic laws of the Contracting
States concerning taxes that the States impose.
The commentary intends the standard of “foreseeable relevance” to be interpreted broadly, but not so
broadly as to extend to “fishing expeditions” and irrelevant information. The test of relevance is at the
time that the State makes its request. It is sufficient that there is a reasonable possibility that the
requested information is relevant at that time, regardless of its subsequent immateriality.
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Thus, the Commentary states:
A “request may therefore not be declined in cases where a definite assessment of the pertinence of
the information to an ongoing investigation can only be made following the receipt of the information.
The competent authorities should consult in situations in which the content of the request, the
circumstances that led to the request, or the foreseeable relevance of requested information are not
clear to the requested State. However, once the requesting State has provided an explanation as to the
foreseeable relevance of the requested information, the requested State may not decline a request or
withhold requested information because it believes that the information lacks relevance to the
underlying investigation or examination.”
Any information received under paragraph 1 by a Contracting State shall be treated as secret in the
same manner as information obtained under the domestic laws of that State and shall be disclosed
only to persons or authorities (including courts and administrative bodies) concerned with the
assessment or collection of, the enforcement or prosecution in respect of, the determination of
appeals in relation to the taxes referred to in paragraph 1, or the oversight of the above. Such persons
or authorities shall use the information only for such purposes. They may disclose the information in
public court proceedings or in judicial decisions. Notwithstanding the foregoing, information received
by a Contracting State may be used for other purposes when such information may be used for such
other purposes under the laws of both States and the competent authority of the supplying State
authorizes such use.
Paragraph 3 imposes important limitations on the power of Contracting States to exchange
information.
(3)
In no case shall the provisions of paragraphs 1 and 2 be construed so as to impose on a
Contracting State the obligation: a) to carry out administrative measures at variance with the laws and
administrative practice of that or of the other Contracting State; b) to supply information which is not
obtainable under the laws or in the normal course of the administration of that or of the other
Contracting State; c) to supply information which would disclose any trade, business, industrial,
commercial or professional secret or trade process, or information the disclosure of which would be
contrary to public policy (ordre public).
The paragraph is clear that “a Contracting State is not bound to go beyond its own internal laws and
administrative practice in putting information at the disposal of the other Contracting State.” Although
the Commentary speaks of cooperation to the “widest extent possible”, it does not overrule domestic
laws, such as the “revenue rule”.
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V.
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Double Taxation of Income and Capital
The first step in determining whether there is juridical double taxation is to ensure that the taxes under
review are in fact comparable taxes. This requires an evaluation of the foreign and domestic tax to
determine their comparability for the purpose of providing appropriate relief. Juridical double taxation
only occurs where there are comparable taxes in respect of the same subject matter.
Multinational corporations (MNCs) will invest money in low-tax jurisdictions to limit their tax liability,
by exploiting tax statutes, regulations, and accounting rules to shift profits and valuable assets
offshore.8 For example, Apple Inc., a U.S. multinational corporation, used offshore structures and
sophisticated tax arrangements to shift billions of dollars in profits away from the United States and
into Ireland, where it received favourable tax incentives. Apple Inc. and Ireland negotiated a special
corporate tax rate at less than Ireland’s domestic corporate tax rate. By establishing Irish subsidiaries,
the company was able to direct a substantial portion of its profits to a lower-tax jurisdiction. In
response, the European Commission issued a “State aid” decision against Ireland, alleging that the
arrangement was illegal.
There are essentially two ways to eliminate double taxation: (a) The country of the taxpayer’s
residence (State R) can unilaterally apply its domestic rules to eliminate it; or (b) A bilateral treaty
between State R and the state of source (State S) can allocate primary and secondary taxing powers
between the states over comparable taxes.
a.
Domestic Provisions to Eliminate Double Taxation
A country can unilaterally relieve against double taxation of international income through its domestic
tax rules. For example, a country can provide tax relief through:
•
•
•
•
A credit for foreign taxes; 9
An exemption of foreign source income; 10
A deduction for foreign taxes paid; or
Restricted taxation on certain forms of income.
Unilateral deductions, exemptions, and foreign tax credits are useful to relieve double taxation, but
they have their limitations. First, they involve a loss of revenue to the granting country by diminishing
their taxable base. Hence, there are financial constraints on the amount of unilateral relief that a
country will be willing to provide.
Second, there are technical problems associated with the interpretation of the meaning of “tax” that
may be eligible for credits and exemptions, which can lead to double taxation of income and, in some
cases, double non-taxation of income. Hence, they need to be supplemented by relief provisions
negotiated through bilateral tax treaties.
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b.
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Foreign Tax Credits
Under a foreign tax credit (FTC) system, the country of residence (R) taxes all foreign source income,
but may allow the taxpayer to reduce its domestic taxes by the amount of taxes that it paid on the
income to the country of source (S). This method eliminates the residence – source conflict. The
foreign tax credit that State R grants through its domestic tax law may be a full, or partial, credit for
foreign taxes.
There are two types of foreign tax credits:
(1) direct credits for all taxes paid on the foreign source income remitted to the country of residence;
and
(2) indirect credits for the foreign enterprise’s underlying foreign tax (UFT), which provide tax relief for
the foreign enterprise’s taxes paid in another country. 11
Jurisdictions that use a foreign tax credit system to eliminate double taxation emphasize capital export
neutrality and do not intend to create incentives for their residents to invest abroad. The theory is that
the total tax burden should be the same regardless whether the taxpayer invests in his residence
country or in a foreign jurisdiction. However, the system works well only if there is agreement on the
concept of what “tax” that is eligible for the foreign tax credit.
For example, an alternative minimum tax that is based on “net assets” may result in the loss of a
foreign tax credit. Thus, Mexico made its assets an “add-on” to its income tax (instead of an alternative
to the income tax) in order to ensure that it would be eligible for the U.S. foreign tax credit. Similarly,
social security taxes can be troublesome if they are not considered taxes for the purposes of the
domestic foreign tax credit.
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Example of Full Direct Tax Credit
Assume that a domestic parent company with a foreign operation earns domestic and foreign source
income. The domestic tax rate of the residence state (State R) is 35%. The foreign tax rate of the source
state (State S) is 30%.
Income
Foreign tax paid
Domestic tax on WWI
Foreign tax credit
Net domestic tax
Total tax paid
Total tax percentage
State R (35% tax)
$400,000
State S (30% tax)
$600,000
$180,000
Total
$1,000,000
$350,000
-$180,000
$170,000
$350,000
35%
In the full credit system, the effective tax rate on the taxpayer’s worldwide income is 35%, which is
equal to State R’s tax rate.
Example of Full Direct Tax Credit
Assume that a domestic parent company with a foreign operation earns domestic and foreign source
income. The domestic tax rate of the residence state (State R) is 35%. The foreign tax rate of the source
state (State S) is 40%.
Income
Foreign tax paid
Domestic tax on WWI
Foreign tax credit
Net domestic tax
Total tax paid
Total tax percentage
State R (35% tax)
$400,000
State S (40% tax)
$600,000
$240,000
Total
$1,000,000
$350,000
-$240,000
$110,000
$350,000
35%
The investor gets a full credit for State S’s taxes of 40%. However, now State R loses revenues to State
S by granting a credit at a rate that is 5% higher than its own rate. Most countries would be reluctant to
grant a full credit in these circumstances.
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Example of Canadian Resident
A Canadian resident who earns investment income in the United States will pay tax on the income in
the U.S. and in Canada. The investor can obtain unilateral relief in Canada through a foreign tax
credit.12 The foreign tax credit prevents double taxation by allowing the Canadian resident to claim a
credit for foreign tax paid on foreign source income. However, there is a limit on the credit up to a
maximum of the Canadian tax rate payable on such income. In effect, the taxpayer pays total tax equal
to the higher of the Canadian and foreign tax rates on the foreign source income. Hence, tax
Conventions, such as, the Canada-United States Tax Convention, typically stipulate the maximum rate
of tax on certain forms of investment income. 13
Foreign tax credits emphasize capital export neutrality so that the tax burden should be the same
whether the investor or entity invests in its country of residence or a foreign jurisdiction. In order to
address neutrality, the foreign tax credit should be determined separately for each type of tax.
Unilateral foreign tax credits deplete the residence country’s treasury by reducing the multinational
corporation’s taxable base.
Example
Assume that State S taxes interest income at 40% on income earned in the State. Harry, a resident of
State R, owns debt securities issued in State S, and pays $40 tax on $100 interest income to R. If State R
also taxes its residents at 40%, and gives Harry a full foreign tax credit for the tax paid to S, its treasury
will forgo $40 in revenue.
Income
Interest income
Tax
Tax credit for tax paid to State S
Net after tax
State S
$100
40
$60
State R
$100
40
-40
$100
The tax credit in State R offsets the full amount of the foreign tax paid to State S. Harry is indifferent
because he pays only $40 in total tax, and is not much concerned to whom he pays it, as long as he
pays only once.
Thus, State R’s foreign tax credit eliminates potential double taxation at the expense of its treasury.
Under this system, State R pays the price for State S’s capital markets. This is not a problem if States R
and S are neutral in their capital exports, as gains and losses in revenues in each State will offset each
other.
The problem is more complicated if State S taxes the income at higher rate than State R, and State R
gives the investor a partial foreign tax credit at its lower domestic tax rate.
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Example
Income
Interest income
Tax
Tax credit
Net after tax
State S (50% rate)
$100
50
$50
State R (40% rate)
$100
40
-40
$100
The investor pays a premium tax of 10% for earning his income outside his country of residence. State
R subsidizes State S’s taxes by providing a foreign tax credit to the tune of $40. Thus, the differential
tax rate will affect the flow of capital investments between States R and S, and affect capital export
neutrality between the two countries.
The foreign tax credit regime may not produce the optimal result for State R. In some cases, the
foreign tax credit regime of State R may provide its domestic investors with an incentive to invest in a
high tax foreign country and reduce the total tax payable to R.
Example
Assume that an investor from State R (tax rate of 35%) can invest in State S1 (tax rate of 30%), and
earn a pre-tax return of $1,000. Alternatively, the investor can invest in State S2 (tax rate of 10%), and
earn a pre-tax return of $900, but with the same risk.
Pre-tax return
Tax paid States S1/S2
State R’s tax
Foreign tax credit
Net tax paid to State R
State S1 (30%)
$1,000
$300
$350
$300
$50
State S2 (10%)
$900
$90
$315
$90
$225
Although the investor pays more tax to S1 than to S2, his overall net return from the higher tax State is
better.
Example
Gross return
Tax paid to S1
Tax paid to S2
Tax paid in R
Net return to investor
State S1 (30%)
$1,000
$300
$50
$650
State S2 (10%)
$900
$90
$225
$585
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Similarly, credits create problems with the principle of capital export neutrality, that is, the taxation of
foreign and domestic profits at the same total rate. It is an “equitable” principle because taxpayers
with the same worldwide income pay the same total amount of total tax. Thus, capital export
neutrality reflects the principle that a dollar is a dollar no matter where it is earned.
Example
Assume that a Canadian corporation is taxed at 35% on its Canadian profits, and pays 50% tax to a
foreign government on its foreign operations.
Income
Tax rates
Foreign tax
Domestic tax WWI
Foreign tax credit
Net domestic tax
Total tax on WWI
Net additional tax
imposed
Domestic
$400,000
35%
Foreign
$600,000
50%
$300,000
Total (WWI)
$1,000,000
$350,000
$210,000
$140,000
$440,000
$90,000
In the above example, the home country has two choices: It can provide an unlimited tax credit for the
full amount of foreign taxes paid (50%), or it can limit the foreign tax credit to a maximum of the
domestic tax rate applicable on such income. By limiting the foreign tax credit to the maximum
domestic rate of 35%, the taxpayer pays an additional tax of $90,000, that is, 15% x $600,000. Thus, the
limitation on the tax credit violates the principle of capital export neutrality. However, the limitation of
35% preserves the domestic tax base. A higher rate would, in effect, subsidize the foreign country’s tax
base.
Domestic law can be a blunt instrument in eliminating double taxation. In the case of foreign tax credit
regimes, for example, domestic law can result in double taxation because of the concept of “tax” that
is eligible for the credit.
Indirect taxes paid by foreign subsidiaries of domestic corporations also create problems if there is no
relief for the underlying foreign tax paid by the subsidiary.
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Example
Assume two situations:
(a) Company A pays direct tax on its corporate profits at a rate of 50%; and
(b) Company B pays no direct taxes but pays indirect taxes of an equal amount.
Both companies distribute their after-tax income to their respective parent companies, which are
resident in a country that levies tax at a rate of 35% on dividends.
Company A
Revenues
$1,000
Costs (incl. indirect taxes)
800
Net income before tax
$200
Direct corporate tax (UFT)
$100
Net income after tax
$100
Dividend received
$100
Gross-up for UFT
100
$200
Corporate tax @ 35%
$70
Less: relief for UFT at lesser $70
of two rates
Net additional tax
$0
Net cash available after tax $100
Company B
$1,000
900
$100
0
$100
$100
0
$100
$35
$0
$35
$65
Company B’s parent company is penalized because it does not receive any credit for the indirect taxes
of $100 that its subsidiary paid in the foreign country. Hence, its net return is reduced by $35.
c.
Exemption Systems
A country may eliminate double taxation of income by exempting certain forms of income from tax.
Under an exemption system, the residents of a country (State R) are taxable only on their domestic
income – that is, income from State R, and are not taxable on foreign source income. The method
completely eliminates any double tax problems created by source-residence conflicts. An exemption
system emphasizes capital import neutrality to ensure that its residents can compete in foreign
jurisdictions.
The full exemption model completely excludes all foreign source income from State R’s tax base in
determining the taxpayer’s tax liability. Hence, it is less important for the residence jurisdiction to
develop a concept of “tax” as it can simply exempt all foreign income from its domestic tax. However,
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this can give rise to double non-taxation. Thus, some countries, such as Belgium, exempt only foreign
income that is “taxed” abroad. Spain uses the concept of “comparable taxes” in its exemption method.
Example
Source of income
Foreign source income
Domestic source income
Worldwide income
Foreign tax payable 40% x 50
Domestic tax payable 35% x 50
Total tax payable
State S (40% rate)
50
State R (35% rate)
Tax Payable
50
100
20.0
17.5
37.5
Unilateral solutions also have economic implications. The exemption method, for example, is nonneutral if the income derives from a country that is a tax haven or low tax jurisdiction. The exemption
system can even result in double non-taxation.
d.
Deduction for foreign taxes
A country can allow a taxpayer to deduct its foreign taxes from its income under its domestic law to
alleviate international juridical double taxation. Under this method, the deduction will reduce the
domestic country’s tax base. The State of source of the income will reap the benefits of the tax. Hence,
more usually, a country may allow a deduction for taxes, but only if the tax credit or exemption
method is not available under a bilateral treaty.
VI.
Double Tax Treaties
None of the domestic systems discussed – tax credit, exemption, or deduction – is entirely satisfactory
in isolation to prevent juridical double taxation of income. We need a supplemental solution. This
typically takes the form of negotiated bilateral double tax conventions (DTCs) between countries to
reduce the incidence of double taxation and disclosure of information.
a.
Background
As early as 1923, the Report of the Four Experts, commissioned by the League of Nations,14 recognized
that double taxation could deter foreign investment and act as a barrier to international trade. Thus,
international bodies developed model tax treaties to reduce such barriers and encourage foreign
investment.
There were few tax treaties before the Second World War. Compared to European countries, Canada
was relatively slow in getting into tax treaties, although, once off the mark it became active in
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negotiating such treaties. Understandably, given the trading and economic relationship between
Canada and the United States, the Canada-U.S. Tax Convention (Canada-U.S. Treaty) is a significant,
and complex, treaty. However, Canada has tax treaties with most developed, and some developing,
countries. The structure of each treaty depends upon the particular Model (OECD, UN or US) that
Canada uses to negotiate each treaty.
Treaties are generally bilateral agreements between States. There are a few exceptions, such as, the
Andean Treaty between several Latin American countries, and the Nordic Treaty between several
Scandinavian countries.
International tax treaties generally operate in silos. Thus, we have taxes on income, capital,
consumption, inheritances, gifts, and social security. The difficulty of silos is that the boundaries of
each silo can be vague or overlap. Thus, they can give rise to double taxation, or double non-taxation,
of income.
b.
International Taxation
“International taxation” is the law of taxation applicable to exchanges of goods, services and
intellectual property across national boundaries. The law of international tax treaties is a subset of
international taxation that deals with conventions and agreements between countries.
“Tax conventions” (also known as double tax agreements (DTAs)) are economic bargains between
countries. Following common usage, we refer to such conventions as tax treaties. A tax treaty is: 15
[…] an international agreement concluded between States in written form and governed by
international law, whether embodied in a single instrument or in two or more related instruments and
whatever its particular designation.
There are many different types of tax treaties – such as, treaties on income and capital, estates and
gifts, inheritance, and on administrative assistance in tax matters. There are also limited scope treaties
that deal with specific industries – for example, shipping and aircraft.
Early tax treaties focused primarily on preventing double taxation. In 1923, the Report of the Four
Experts, a Commission of the League of Nations,16 recognized that double taxation could deter foreign
investment, and act as a barrier to international trade. Thus, international bodies developed Model tax
treaties to reduce such barriers and encourage foreign investment.
As trade and commerce have become more global, some newer treaties are also concerned with the
prevention of fiscal evasion and exchange of information between countries. For example, the U.S.
Model Income Tax Convention (2016) states in its title that the Convention is between:
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“THE GOVERNMENT OF THE UNITED STATES OF AMERICA
AND THE GOVERNMENT OF __________
FOR THE AVOIDANCE OF DOUBLE TAXATION AND THE
PREVENTION OF TAX EVASION
WITH RESPECT TO TAXES ON INCOME”
Similarly, the Canada-United Kingdom Tax Convention specifies that the purpose of the treaty is the
“avoidance of double taxation” and the “prevention of fiscal evasion” with respect to taxes on income
and capital gains.
c.
Model Tax Treaties
There are three major models: (1) OECD Treaty; (2) UN Model Convention; and (3) US Model Treaty. All
three have the same two broad purposes, but apply in different ways.
The first is to eliminate double taxation of income that residents of one country earn from sources
within the other country. Eliminating double taxation promotes closer economic cooperation between
treaty countries and reduces barriers to trade caused by overlapping taxing jurisdictions. The Models
achieve this by providing that the country of residence will eliminate double taxation of income by
allowing a foreign tax credit for foreign income or by exempting the income from tax. Additionally,
they provide that the source country will reduce the scope of its jurisdiction to tax income at source by
reducing its withholding tax on income that a non-resident earns in the country.
The second purpose is to reduce tax avoidance and evasion of income taxes in international trade and
commerce.
Countries use model tax treaties as a starting point when negotiating their bilateral tax treaties. The
United Nations Model Convention (UNMC), and the Organization for Economic Co-operation and
Development (OECD) Model Tax Convention on Income and on Capital (the OECD Model Convention),
are the two most widely used models. They are the source for most of the more than 3,000 tax treaties
in force, thus providing a profound influence on international tax treaty practice.
The United Nations Model Double Taxation Convention between Developed and Developing Countries
(the United Nations Model Convention) is relied upon more by developing countries, while the OECD
Model Convention tends to be relied upon more by developed countries though elements of the UN
Model have influenced the OECD Model and OECD Member country practice.
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The UN Model, which developing countries use in negotiating treaties with developed countries, serves
an additional purpose. In addition to eliminating double taxation and reducing inappropriate tax
avoidance and evasion, the UN Model also promotes politically acceptable investment in developing
countries. 17 As the UN Commentary states: 18
“The desirability of promoting greater inflows of foreign investment to developing countries on
conditions which are politically acceptable as well as economically and socially beneficial has been
frequently affirmed in resolutions of the General Assembly and the Economic and Social Council of the
United Nations and the United Nations Conference on Trade and Development.
Broadly speaking, the general objectives of bilateral tax conventions may today be seen to include the
full protection of taxpayers against double taxation (whether direct or indirect) and the prevention of
discouragement which taxation may provide for the free flow of international trade and investment
and the transfer of technology. They also aim to prevent discrimination between taxpayers in the
international field, and to provide a reasonable element of legal and fiscal certainty as a framework
within which international operations can be carried on. With this background, tax treaties should
contribute to the furtherance of the development aims of the developing countries. In addition, the
treaties have as an objective the improvement of cooperation between taxing authorities in carrying
out their duties.”
Thus, the UN Model is more than a fiscal instrument. It is also a vehicle for subsidies and foreign aid
under the guise of fiscal legislation.
There is some tension in treaties between developed and developing countries. Developed countries
adopt the OECD approach − tax credits, exemptions and reduction in withholding taxes − as
appropriate in the negotiation of bilateral tax treaties; developing countries do not. This approach
causes the residence country to yield its jurisdiction to tax foreign source income. However, developing
countries are much more reluctant to reduce their yield on source taxation. Indeed, some developing
countries say that the source country should have the exclusive jurisdiction to tax income arising in the
country. The UN Model does not go that far.
The United States has its own Model Convention, which it uses for negotiating its bilateral treaties. The
U.S. Model (developed by the US Treasury) is similar to the OECD Model in most respects, but has
some unique features that are of particular concern to the United States, particularly in connection
with tax havens and treaty shopping. As a capital and intellectual property exporting country, the
United States adopts the position in all its treaty negotiations that the country of source of income
should defer to the country of residence in taxing royalties and rentals from intellectual property.
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Interpretation
Although tax treaties are bilateral agreements, their interpretation in dispute resolution is much more
complex than in domestic contracts. Since they are international treaties, the rules of interpretation of
the Vienna Convention (1969) apply. Canada applies the provisions of the Vienna Convention
in good faith in accordance with the ordinary meaning of words read in context, and in light of its
objects and purpose. 19 Where the provisions of a treaty and the Income Tax Act (Canada) are
inconsistent, the provisions of the treaty prevail to the extent of the inconsistency. Thus, in a sense,
Canada’s tax treaties are “elevated” domestic law.
However, not all countries (most notably, the United States) have ratified the Vienna Convention. The
United States cannot constitutionally allow its domestic law to be subservient to a foreign treaty.
However, the United States tacitly accepts the terms of the Vienna Convention in interpreting its
treaties, but without actually formally ceding its sovereign jurisdiction.
e.
Scope of Tax Treaties
International tax treaties are binding on the signatories to the treaty. 20 The Vienna Convention, a treaty
that deals with the subject of treaties – their making, observance, entry into force, amendment,
suspension of operation, modification and termination − provides a comprehensive set of principles
and rules for the interpretation of treaties.
Income tax treaties apply to residents of the Contracting States. Article 1 of the OECD Model
Convention (2014), for example, states:
“This Convention shall apply to persons who are residents of one or both of the Contracting States.”
Similarly, paragraph 1 of Article 1 of the United States Model Tax Convention provides:
“This Convention shall apply only to persons who are residents of one or both of the Contracting
States, except as otherwise provided in this Convention.”
Similarly, Article 1 of the UN Model Convention:
“This Convention shall apply to persons who are residents of one or both of the Contracting States.”
Income tax treaties address five basic questions:
1.
2.
3.
4.
Nature of Income: What is the character of income that a taxpayer derives?
Source: What is the source of the taxpayer’s income?
Jurisdiction: Who has the primary and secondary jurisdiction to tax transactional income?
What relief, if any, is provided for the particular tax?
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5. Enforcement: How do we enforce tax collection, avoid double taxation and prevent tax
evasion?
Taxpayers can invoke treaty benefits and apply treaty provisions. Paragraph 2 of Article 1 of the US
Model, for example, explicitly states this principle:
“This Convention shall not restrict in any manner any benefit now or hereafter accorded:
a) by the laws of either Contracting State; or
b) by any other agreement to which both Contracting States are parties.”
A taxpayer can choose the benefits of the domestic law or the treaty. He cannot, however, “cherry
pick” by choosing the domestic law for one part of the result, and the treaty for another.
DTAs do not impose taxes. Rather, they generally allocate taxing powers, and limit the power of
Contracting States to impose taxes above agreed upon levels. 21 For example, a DTA may limit the tax
on interest income earned in the source country to 15%. That does not mean, however, that the
source State must impose any tax on interest payments to non-residents.22 It merely stipulates the
maximum amount that the State may impose. Thus, a tax treaty is a shield, not a sword.
f.
Meaning of “Tax” in Treaties
The underlying rationale of DTAs is the prevention of juridical double taxation. Hence, the first task is
to determine the meaning and nature of “tax” as used in bilateral tax treaties.
Tax treaties based on the OECD Model Convention on Income and Capital apply to taxes on income
and to taxes on capital. Hence, to qualify for relief under the particular treaty the tax must first qualify
as such under domestic and treaty rules.
Domestic tax statutes do not define “tax”. Thus, we must initially look to the case law to distinguish
between taxes and other levies, such as, fines, penalties, duties, fees, and licence fees. This is
important not only for the purposes of tax law, but also for constitutional reasons. For example, Article
1 – “Protection of property” under the Protection of Human Rights and Fundamental Freedoms (as
amended) provides:
“Every natural or legal person is entitled to the peaceful enjoyment of his possessions. No one shall be
deprived of his possessions except in the public interest and subject to the conditions provided for by
law and by the general principles of international law.
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The preceding provisions shall not, however, in any way impair the right of a State to enforce such laws
as it deems necessary to control the use of property in accordance with the general interest or to
secure the payment of taxes or other contributions or penalties.”
Tax treaties do not define taxes, but merely list them in Article 2. Hence, the interpretation of what
constitutes a tax is a matter of domestic law. Tax treaties generally apply to taxes on income and taxes
on capital, which leaves open the question whether it should be given its domestic meaning or a wider
contextual meaning. For example, some countries, such as the United States, apply the doctrine of
substance over form in their domestic law; others, such as Canada do not.
The Income Tax Act (Canada) does not define either “income”, “capital”, or “tax”. Canadian courts have
developed the meaning of the terms in case law. Although there are several sources that define “tax”
in various contexts, their common theme is that taxes are an enforced contribution that a state levies
by virtue of its sovereignty to support its operations and public needs.
There are four essential requirements for a levy to qualify as a tax:
1.
2.
3.
4.
A tax is a compulsory levy;
Taxes are imposed by an organ of government;
Tax revenues are collected for general public purposes;
Taxpayers do not derive specific or particular benefits from the taxes collected.
In summary, taxes are compulsory exactions of money by public authorities for public purposes,
enforceable by law, and are not a payment for services rendered. 23
However, the borderline between taxes and other compulsory charges is not always clear and definite.
For example, compulsory social security payments that provide specific benefits to individuals may be
payroll taxes, even though they provide specific retirement benefits to recipients.
Legislatures sometimes describe taxes as “charges”, “exactions”, “penalties”, or “duties”. The common
element of all taxes is that they are mandatory and coercive. 24 They “operate in invitum – against an
unwilling person. 25
Taxes are painful. Hence, politicians like to attach soft labels to taxing statutes to lessen their pain. For
example, in 1996 Premier Dalton McGuinty of Ontario introduced the Fair Share Health Care Levy
(FSHCL), and, in 2004, a health care “premium”. Both the levy and the premium were in substance
“taxes”.
Similarly, President Obama of the United States introduced the Patient Protection and Affordable Care
Act (2012) (“Obamacare”) as health insurance coverage. The Act requires that individuals pay a
“penalty” to the Internal Revenue Service if they do not have or purchase coverage. Obamacare allows
individuals who choose to pay the penalty to buy their way out of buying the mandated health
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insurance. The United States government estimated at the time of its enactment that six million people
each year would choose to pay the IRS the penalty for doing nothing. Thus, the tax is, in effect, levy a
tax on inertia. The United States Supreme Court in a 5:4 decision held the “penalty” to be a tax, and,
hence, constitutional under the U.S. federal power over taxation.
The statutory label of a levy is important for political purposes. However, it is irrelevant in determining
the legal character of the levy. Courts have held exactions not to be taxes even when labeled as such,
and to be taxes when not so labeled.
There are several criteria to determine whether a levy is in fact a tax or a penalty. A tax raises revenue
for public expenditures by attaching to an event – for example, earning income, buying goods and
services, or engaging in an activity. In contrast, a penalty is a punitive sanction for doing something
that is considered harmful and, in most cases, requires the actor to have knowledge of the wrongful
act. In distinguishing penalties from taxes, the United States Supreme Court stated that “if the concept
of penalty means anything, it means punishment for an unlawful act or omission.” 26
To be sure, both taxes and penalties affect conduct, but they do so in different ways. Tax provisions
are often used for purposes other than to raise revenue. For example, taxes on cigarettes not only
raise substantial revenues for governments, but are also intended to encourage people to give up
smoking for health reasons. In contrast, governments use liquor taxes primarily to raise revenues, but
without excessive concern for health.
Thus, every tax is in some measure regulatory in that it poses an economic impediment to the activity
taxed, as compared with others that are not taxed. In contrast, penalties imply punishment for an
unlawful act or omission – such as, for example, failure to secure a motor vehicle permit or a dog
license.
Taxpayers do not receive specific measurable benefits from their taxes. A tax is simply an enforced
contribution pursuant to constitutional legislative authority to raise revenue for public purposes, and
not as a payment for some special benefit or service. Taxpayers do, however, indirectly derive benefits
from government services – such as, national defense, health care, social services, public schools,
judicial services, and public roads, etc. As Justice Holmes said: “Taxes are what we pay for civilized
society.” 27
There is no universal definition of “tax on income” or “tax on capital”. A treaty may contain a general
definition, or provide an exhaustive list. Others may simply list the taxes, and then specify some taxes
“in particular”.
Article 3 of the OECD Model does not provide a definition of “tax”. Hence, its interpretation is a matter
of domestic law.
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However, paragraphs 11 to 13.1 of the OECD Commentary on Article 3 comment on the appropriate
choice of law in the interpretation of terms not defined in a treaty.
"This paragraph provides a general rule of interpretation for terms used in the Convention but not
defined therein. However, the question arises which legislation must be referred to in order to
determine the meaning of terms not defined in the Convention, the choice being between the
legislation in force when the Convention was signed or that in force when the Convention is being
applied, i.e. when the tax is imposed. The Committee on Fiscal Affairs concluded that the latter
interpretation should prevail, and in 1995 amended the Model to make this point explicitly.
However, paragraph 2 specifies that this applies only if the context does not require an alternative
interpretation. The context is determined in particular by the intention of the Contracting States when
signing the Convention as well as the meaning given to the term in question in the legislation of the
other Contracting State (an implicit reference to the principle of reciprocity on which the Convention is
based). The wording of the Article therefore allows the competent authorities some leeway.
Consequently, the wording of paragraph 2 provides a satisfactory balance between, on the one hand,
the need to ensure the permanency of commitments entered into by States when signing a convention
(since a State should not be allowed to make a convention partially inoperative by amending
afterwards in its domestic law the scope of terms not defined in the Convention) and, on the other
hand, the need to be able to apply the Convention in a convenient and practical way over time (the
need to refer to outdated concepts should be avoided).
Paragraph 2 was amended in 1995 to conform its text more closely to the general and consistent
understanding of member states. For purposes of paragraph 2, the meaning of any term not defined in
the Convention may be ascertained by reference to the meaning it has for the purpose of any relevant
provision of the domestic law of a Contracting State, whether or not a tax law. However, where a term
is defined differently for the purposes of different laws of a Contracting State, the meaning given to
that term for purposes of the laws imposing the taxes to which the Convention applies shall prevail
over all others, including those given for the purposes of other tax laws. States that are able to enter
into mutual agreements (under the provisions of Article 25 and, in particular, paragraph 3 thereof) that
establish the meanings of terms not defined in the Convention should take those agreements into
account in interpreting those terms."
Article 2 of the OECD Model states:
“1. This Convention shall apply to taxes on income and on capital imposed on behalf of a Contracting
State or of its political subdivisions or local authorities, irrespective of the manner in which they are
levied.
(Canada, Chile and the United States reserve their positions on the part of paragraph 1 that states that
the Convention should apply to taxes of political subdivisions or local authorities.)
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2. There shall be regarded as taxes on income and on capital all taxes imposed on total income, on
total capital, or on elements of income or of capital, including taxes on gains from the alienation of
movable or immovable property, taxes on the total amounts of wages or salaries paid by enterprises,
as well as taxes on capital appreciation.
3. The existing taxes to which the Convention shall apply are in particular: a) (in State A):
.......................................... b) (in State B): ..........................................
4. The Convention shall apply also to any identical or substantially similar taxes that are imposed after
the date of signature of the Convention in addition to, or in place of, the existing taxes. The competent
authorities of the Contracting States shall notify each other of any significant changes that have been
made in their taxation laws.”
Paragraph 1 of the Article establishes the baseline as “taxes on income or capital”, whereas paragraph
2 attempts to amplify the meaning of the two forms of taxes.
Paragraph 3 is muddled. It is intended to particularize the specific taxes that the treaty covers, but then
makes the list non-exhaustive by stating that the listed taxes are only “in particular” and that the list is
not exhaustive.
Paragraph 4 tells us that the Article also includes any taxes imposed after the signing of the treaty,
provided that they are “identical or substantially similar” to existing taxes. However, any such
subsequent taxes would likely be within the scope of the general provision in paragraph 2.
Where a treaty incorporates Articles 2(1) and 2(2) of the OECD Model, the list in Article 2(3) may be
considered illustrative only and not exhaustive. Paragraph 6 of the OECD Commentary to the Article
states:
“This paragraph lists the taxes in force at the time of signature of the Convention. The list is not
exhaustive. It serves to illustrate the preceding paragraphs of the Article. In principle, however, it will
be a complete list of taxes imposed in each State at the time of signature and covered by the
Convention.
Some member countries do not include paragraphs 1 and 2 in their bilateral conventions. These
countries prefer simply to list exhaustively the taxes in each country to which the Convention will
apply, and clarify that the Convention will also apply to subsequent taxes that are similar to those
listed.”
Most countries have adopted Article 2 of the OECD Model (or its near equivalent in the UN Model) in
their bilateral treaties. However, some treaties will specifically exclude certain forms of taxation, such
as, social security and unemployment taxes. Thus, for example, Article 2 of the U.S. Model Convention
provides:
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“1. This Convention shall apply to taxes on income imposed on behalf of a Contracting State
irrespective of the manner in which they are levied.
2. There shall be regarded as taxes on income all taxes imposed on total income, or on elements of
income, including taxes on gains from the alienation of property.
3. The existing taxes to which this Convention shall apply are:
a) in the case of __________:
b) in the case of the United States: the Federal income taxes imposed by the Internal Revenue Code
(which do not include social security and unemployment taxes) and the Federal taxes imposed on the
investment income of foreign private foundations.
4. This Convention also shall apply to any identical or substantially similar taxes that are imposed after
the date of signature of this Convention in addition to, or in place of, the existing taxes. The competent
authorities of the Contracting States shall notify each other of any significant changes that have been
made in their taxation laws or other laws that relate to the application of this Convention.”
Where a treaty embodies only Article 2(3), the list of taxes enumerated therein is exhaustive of the
taxes covered. For example, unlike Article 2 in the OECD Model, the equivalent U.S. Model Article does
not contain a general description of the types of taxes that are covered (i.e., income taxes), but only a
listing of the specific taxes covered for both of the Contracting States. Hence, with two exceptions, the
taxes specified in Article 2 would be the covered taxes for all purposes of the Convention.
Under the US Model, a broader coverage applies, however, for purposes of Articles 24
(Nondiscrimination) and 26 (Exchange of Information and Administrative Assistance). Article 24
(Nondiscrimination applies with respect to all taxes, including those imposed by state and local
governments. Article 26 (Exchange of Information and Administrative Assistance) applies with respect
to all taxes imposed at the national level. 28
g.
Treaty Enforcement
Enforcement of treaties depends upon the constitutional structure of the particular country. Under
Canadian constitutional law, for example, Parliament and provincial legislatures have the sole authority
to levy taxes. Thus, Canada specifically legislates its tax treaties into its domestic law.
In theory, Canada could indirectly levy taxes through a treaty and then enact the taxes by adopting the
treaty as part of domestic law through its normal constitutional processes. In fact, Canada has never
done so.
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The United Kingdom also limits its taxing powers. The U.K. Bill of Rights of 1688 provides:
That levying money for or to the use of the Crown by pretence of prerogative without grant of
Parliament for longer time or in other manner than the same is or shall be granted is illegal. 29
h.
Purpose of Tax Treaties
Tax treaties have two broad purposes. The first is to eliminate double taxation of income that residents
of one country earn from sources within the other country. Eliminating double taxation promotes
closer economic cooperation between treaty countries and reduces barriers to trade caused by
overlapping taxing jurisdictions. Typically, tax treaties seek to prevent double taxation either by
exempting particular types of income from tax or by stipulating a maximum rate at which the income is
taxed.
The second purpose is to reduce tax avoidance and evasion of income taxes in international trade and
commerce.
The OECD Model Convention – which developed countries use as their starting point in treaty
negotiations – prevents double taxation through two fundamental mechanisms. It provides that:
1. The country of residence will eliminate double taxation of income by providing a foreign tax credit for
foreign income, or by exempting the income from tax; and
2. The source country will reduce the scope of its jurisdiction to tax income at source by reducing its
withholding tax on income that a non-resident earns in the country.
Developing countries use the UN Model Convention, which serves an additional purpose, the
promotion of politically acceptable investment in developing countries. 30 Hence, the UN Commentary
states: 31
The desirability of promoting greater inflows of foreign investment to developing countries on
conditions which are politically acceptable as well as economically and socially beneficial has been
frequently affirmed in resolutions of the General Assembly and the Economic and Social Council of the
United Nations and the United Nations Conference on Trade and Development.
Broadly speaking, the general objectives of bilateral tax conventions may today be seen to include the
full protection of taxpayers against double taxation (whether direct or indirect) and the prevention of
discouragement which taxation may provide for the free flow of international trade and investment
and the transfer of technology. They also aim to prevent discrimination between taxpayers in the
international field, and to provide a reasonable element of legal and fiscal certainty as a framework
within which international operations can be carried on. With this background, tax treaties should
contribute to the furtherance of the development aims of the developing countries. In addition, the
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treaties have as an objective the improvement of cooperation between taxing authorities in carrying
out their duties.
As a consequence of the differences between the Models, there is tension in negotiating treaties
between developed and developing countries. Developed countries consider the OECD approach − tax
credits, exemptions and reduction in withholding taxes − as appropriate in the negotiation of bilateral
tax treaties; developing countries do not necessarily agree.
Developing countries accept the first principle – reduction of taxes by the country of residence through
a tax credit or exemption for foreign income, which results in the residence country yielding its
jurisdiction to tax foreign source income. However, developing countries are much more reluctant to
reduce their own yield on source taxation. The issue is as much political as it is economic. Indeed, some
developing countries say that the source country should have the exclusive jurisdiction to tax income
arising in their country. The UN Model does not go that far.
i.
Bilateral Negotiations
Tax treaties may be bilateral or multilateral. The negotiation of tax treaties is a long and arduous
process that can extend over many years. The complexity of a particular treaty depends upon the
economic relationship between the treaty partners. For example, it took Canada and the United States
more than 30 years to negotiate the 1980 version (current) of the Canada-US Tax Treaty, which the
two countries have since updated through several Protocols.
Treaties between developed and developing countries are even more complex because of the
economic and political imbalance between the two negotiating partners. Further, any treaty with the
United States is intrinsically more complicated because of its economic clout, and its insistence on a
limitation of benefits (LOB) article in all of its treaties. Each LOB varies from the US Model Treaty to
account for differing economic relations between countries.
VII.
International Tax
We use the term “international tax” in two distinct senses. First, the term refers to the body of rules in
a domestic fiscal statute that deal with international transactions – for example, credits for foreign
taxes paid. In a broader context, however, “international tax” refers to a body of law created largely,
but not exclusively, through the negotiation of bilateral tax treaties between countries to allocate
jurisdiction to tax between countries.
The term “international tax” is actually a misnomer. There is no uniform or over-arching body of
international law that governs taxes. International tax is really an aggregate of negotiated treaties that
countries import into their domestic law. Unlike public international law, there is no central body or
judicial tribunal that adjudicates international tax disputes. Instead, we litigate international tax issues
within domestic judicial systems.
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In Canada, for example, legal actions involving international tax start in the Tax Court of Canada, then
move to the Federal Court of Appeal, and then (by leave) to the Supreme Court of Canada. In contrast,
the European Union actually has a body of law that crosses the national boundaries of its member
states. The EU issues directives that govern the treatment of certain types of transactions between
taxpayers of the member countries. For example, the EU has a Directive on the treatment of payments
between parent and subsidiary companies. 32
Tax treaties 33 may deal with direct and indirect taxes. Direct taxes are income taxes, estate taxes, gift
taxes, wealth taxes and social security taxes. Indirect taxes include value added taxes (VAT), goods and
services taxes (GST) and customs duties.
a.
Characterization of Income, Identification of Source, and Allocation of Jurisdiction
A state must have nexus with the income that it seeks to tax. Countries have jurisdiction to tax only
within their sovereign scope. They cannot impose their tax systems on other sovereign countries. The
“taxable subject” must be within the legal jurisdiction of the country that seeks to impose its taxes on
him, her or it.
A common form of nexus is economic allegiance between the taxing state and the income that it seeks
to tax.34 For example, Canada cannot tax a resident or citizen of the United States unless he or she has
sufficient economic nexus with Canada. The nexus may derive dual residence status, from earning
income, or disposing of property, in Canada.
Most countries typically group taxpayers into two broad categories: residents and non-residents. A
country may exert jurisdiction over its residents on their worldwide income – in effect, unlimited tax
liability. However, it cannot exert jurisdiction over non-residents unless the person has some
connection with the country, either by earning income or disposing of property within it – in effect,
limited tax liability.
Bilateral tax treaties can reallocate or assign jurisdiction to tax income between the treaty partners.
For example, a treaty may provide that a resident of a country who earns income from real property in
the other country may be taxable only by the source state. 35 In effect, the residence country cedes
jurisdiction to tax to the source country.
Typically, treaty countries tax non-resident investors on their income in the source country in one of
two ways: Business income on a net basis – that is, gross income minus deductions to earn the
income; and investment income – such as, dividends, interest and royalties – on a gross basis through a
withholding tax. In order to accommodate for differences between the effective rate of taxes on net
and gross income, the withholding tax rate on investment income is usually lower than taxes on net
income.
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b.
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Policy Objectives
Most countries want to promote international trade and commerce that contributes to their own
economies and national treasuries. However, international trade and commerce is viable only if
individuals and multi-national corporations can engage in transactions on a fair and level playing field,
and with certainty as to the income tax consequences.
A MNC’s net return on equity depends upon several factors – such as, profit margins, asset efficiency
and financial structure. The amount of tax that it must pay domestically and internationally is a key
element in determining the MNC’s net retention rate. The tax burden depends upon the domestic law
of the country and the impact of negotiated treaties. Higher taxes reduce economic activity and can
drive investment to lower-taxed jurisdictions. Foreign owned MNCs are particularly vulnerable to
source country domestic politics. They don’t vote and they are easy whipping boys.
In the simplest case, for example, the United States imposes a domestic withholding tax of 30 percent
on income that a US resident remits to a non-resident. The United States, however, reduces its
withholding tax from 30% to 15, 10, 5 or 0% in many of its income tax treaties. The reduction in
withholding taxes has two separate effects: (1) it reduces the amount of income tax revenue that goes
into the US treasury, and (2) it stimulates the inflow of investments and revenue into the United States
from countries with which it has tax treaties. A country should look at the net benefit that accrues to it
as a result of these two factors, tax rates and investment flows.
In addition to tax equity and economic efficiency, most countries also want to adopt “neutral” tax
policies that do not distort investments decisions and capital flows.
c.
Inbound Investments – Capital Import Neutrality
Capital import neutrality refers to the income tax treatment of capital inflows from foreign investors –
“inbound investments.” Countries generally do not want to treat their foreign investors more
favourably than they treat domestic taxpayers. Thus, all investors – domestic and foreign – should bear
the same effective rates of taxes. Capital import neutrality is fair and equitable; it is also efficient in
economic terms.
To be sure, some countries deliberately deviate from the principle of capital import neutrality in order
to attract foreign investors into the country by providing special incentives, exemptions and tax-free
zones. In particular, developing countries that need to attract foreign capital sometimes provide
economic incentives that outweigh tax fairness and equity. For example, India and China have Special
Economic Zones (SEZs) to attract foreign investments in certain parts of the country and into certain
types of activities. SEZs attract investments by providing partial or complete tax holidays for limited
terms. In these circumstances, the country must carefully monitor and regulate the incentive system.
Otherwise, the system might be an incentive for domestic investors to export their capital to an entity
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in a foreign country and then directly, or indirectly, re-import the capital in order to take advantage of
reduced tax rates on inbound investments.
India was one of the first in Asia to recognize the effectiveness of the Export Processing Zone (EPZ)
model in promoting exports. It set up Asia’s first EPZ in Kandla in 1965. The purpose was to overcome
shortcomings and the restrictive bureaucracy that foreign companies experienced because of the
multiplicity of controls and clearances, the absence of world-class infrastructure and an unstable fiscal
regime. India announced its first SEZ Policy in April 2000.
The main objectives of the Indian SEZ Act are to:
(a)
generate additional economic activity;
(b)
promote exports of goods and services;
(c)
promote investment from domestic and foreign sources;
(d)
create employment opportunities; and
(e)
develop of infrastructure facilities.
d.
Withholding Taxes
Withholding taxes are an easy way to collect taxes at the source of payment. The ultimate effect of
withholding taxes is a complex amalgam of factors that depends upon the investor’s domestic tax
system and the tax burden in the country in which the investor earns its income – the source country.
Typically, a withholding tax system requires the paying party to withhold taxes at the source country’s
domestic rate, unless a treaty with the payee’s country varies the rate. For example, Canada requires
its residents to withhold 25% of the gross amount of dividends paid to a non-resident payee. 36 Thus, a
non-resident investor who earns $100 dividends in Canada will, absent special treaty provisions,
receive only $75 in actual payment. The payer must withhold 25% and remit it on the non-resident’s
behalf to the Canadian tax authorities. The investor may be able to claim a credit for the withheld taxes
when it files its tax return in its country of residence.
If the investor is a resident of a country with which Canada has a treaty, the withholding tax will be
capped not to exceed a stated percentage of the gross amount of the dividend. 37 For example, the
Canada-UK Tax Treaty caps the maximum amount that the Canadian government can impose on
foreign investors in respect of dividend income at 15%. Thus, the Treaty initially improves the
investor’s rate of return on equity from the source country. However, the investor’s ultimate net
return on equity depends upon the tax credit that it receives for foreign taxes when it files its returns
in its country of residence. The tax credit may be less than, equal to, or more than the taxes withheld. 38
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e.
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Outbound Investments – Capital Export Neutrality
The best indicator of pure economic efficiency is the pre-tax rate of return on an investment. Taxes
distort the efficient allocation of economic resources in international markets if the tax system is
biased in favour of, or against, foreign investment income. Just as the international tax community is
concerned with treating inbound investments in a fair and neutral manner, so also is it concerned with
the equitable treatment of outbound investments.
Capital export neutrality promotes tax equity and economic efficiency by being neutral in the taxation
of domestic and foreign income. From the investor’s perspective, the essential question is whether his
country of residence will tax his income in the same manner – and at the same effective rate –
regardless whether he earns the income at home or abroad. The fairer and more neutral the system,
the greater the mobility of capital. Capital export neutrality allows investors to make their decisions
based upon economic returns without the distorting effects of differential tax laws for domestic and
foreign income.
A country achieves capital export neutrality by taxing its residents on their world-wide income. Thus,
under an export neutral system, a resident is taxable on his domestic income in the same manner as he
would be if he earns the income in a foreign country. However, the investor’s country of residence
must recognize, and compensate for, foreign taxes that the investor pays in the source country where
he earns the income. In a perfectly harmonized system, the total taxes payable in the country of
residence, net of credits for foreign taxes paid to the source country, should be equal to the tax that
the investor would have paid had he invested in his home country.
Both capital import and capital export neutrality seek to level the economic playing field. Capital export
neutrality facilitates the efficient allocation of economic resources globally and maximizes risk adjusted
after-tax rates of return on equity. For example, assume that an investor can earn $100 on an
investment in his country of residence, where he pays tax on the income at 35%. His after-tax return is
$65. Assume also that the investor can earn $120 in a foreign country that also taxes investment
income at 35%. In these circumstances, the investor can increase his after-tax return to $78 – an
improvement of 13% in after-tax return on equity – by moving his investment to the higher returns.
The investor will improve his returns by shifting his investment to an “equal risk” foreign source with a
higher rate of return, but only if his country of residence has a neutral capital export tax system. The
investor would expect to receive a tax credit of 35% – equal to the taxes he paid to the source country.
If the residence country does not provide any tax credit on foreign source income, the investor will not
invest abroad because the combined domestic and foreign tax on investment income would be a
massive 84 percent burden.
Domestic tax systems often distort economic returns and capital investment decisions. For example,
under the Canadian foreign affiliate rules, dividends from a Canadian corporation’s foreign subsidiaries
are not taxable in Canada if the subsidiary earns its income from an active business in a country with
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which Canada has a tax treaty. The rule applies regardless of the rate of tax that the foreign subsidiary
pays in the treaty country. Thus, Canadian MNCs have an incentive to invest in, or through, treaty
countries with a low rate of domestic corporate tax to enhance their global returns.
For example, Barbados has a domestic tax rate of approximately 2.5% on international business
corporate income; Ireland has a domestic tax rate of 12%. Thus, even if it would be more efficient to
invest domestically and earn a higher rate of return, the after-tax impact can distort the economic
decision as to where to locate a foreign subsidiary. The net impact in certain industries – for example,
technology, which is highly mobile – is that it is more efficient in after-tax terms for Canadian MNCs to
locate their subsidiaries in low tax foreign jurisdictions.
VIII.
Anti-Avoidance Rules
Tax law is beset with anti-avoidance rules of varying degrees of complexity, scope and certainty. This is
as true in international tax law as it is in domestic tax systems. Taxpayers have an economic incentive
to reduce the tax drag on their returns on equity and will seek out ways to do so. Taxpayers will always
seek ways to move economic activities and investments from high (or higher) tax jurisdictions to
countries with low (or lower) tax rates. There is an entire industry of international tax lawyers and
accountants in perpetual search of creative methods of tax reduction.
Governments, on the other hand, are increasingly concerned with losing tax revenues through
innovative and creative domestic and international tax plans. Thus, governments seek to plug tax
leakage that results from aggressive international planning – much of it conducted by former
government employees who find that their own rate of return improves considerably when they hire
out their services in the private sector.
Tax treaties seek to prevent fiscal evasion through various mechanisms: technical rules, transfer
pricing controls, abuse of law provisions and negotiated limits on treaty benefits.
Canada has a treaty with Ireland, which taxes its domestic corporations at approximately 12.5%.
Ireland may not be a tax haven, but it is an extremely “friendly country” for non-resident companies.
Resident companies are taxable in Ireland on their worldwide profits (including gains). Non-resident
companies are subject to Irish corporation tax, but only on the trading profits of an Irish branch or
agency, and to Irish income tax (generally by way of withholding) on certain Irish-source income.
These treaties allow Barbados ICBs, and Irish companies, to repatriate active business income t o
Canada tax-free.
These relationships between Canada and low tax countries encourage taxpayers to shop for treaties
that provide an expeditious route – a practice known as “treaty shopping.” Countries employ various
provisions to counter “abusive” tax avoidance. Canada, for example, has anti-abuse provisions in its
domestic law − the General Anti-Avoidance Rule39 – that it can also apply to treaties. 40
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Treaty Policies
If all countries had identical tax rates on all sources of income and equal capital flows, there would be
little to gain from tax treaties. That, however, is not, never has been, and never shall be the landscape
of international taxation. Hence, treaties play an important role in international commerce.
Typically, only full (high) tax countries enter into treaties with each other in order to allocate revenues
between their treasuries. Tax havens have little incentive to enter into treaties since they have little to
offer in return to high tax countries, and even less to gain. Sitting in between high tax countries and tax
havens are “treaty havens”, which may be full tax jurisdictions for domestic purposes but havens for
certain foreign investments. For example, a treaty haven may tax its domestic taxpayers at tax rates of
35%, but tax foreign investors at only 2.5% on business income earned within its jurisdiction. These
countries (such as Cyprus, Barbados) are attractive conduits and are often used as stepping-stones
between high tax countries, which promotes “treaty shopping”.
The focus of tax treaties is to promote international trade and commerce. In negotiating treaties,
however, countries are understandably mindful of their own economic interests, capital flows into and
out of the country. Thus, treaties are economic negotiations whereby each negotiating country will
promote its own interests, which creates inevitable tension between the economic interests of the
country of source of income and the country where the taxpayer is resident.
The tension is reduced where countries have equal economic power. It is greatest where there is
unequal economic bargaining power between developing and developed countries. For example, a
developing country that imports technology will prefer to tax any royalty income payable at source in
the country in order to enhance its treasury. In contrast, a country, such as the United States, that
exports technology and other intellectual property will prefer to have the royalty payments taxed in
the country of residence.
IX.
Double Taxation of Income
There are two broad categories of treaties: (1) double tax treaties to mitigate double taxation of
income and capital; and (2) tax information exchange agreements (TIEAs) to control tax avoidance and
evasion.
Double taxation of income and capital is the greatest threat to MNCs and individuals engaged in
international business. Double taxation, the imposition of comparable taxes in two states on the same
taxpayer in respect of the same subject matter and for identical periods, arises because countries may
assert taxing jurisdiction on the basis of different criteria. For example, countries can tax income based
upon the source of income, situs of the underlying property, residence of the taxpayer, or the
taxpayer’s nationality. We refer to multiple tax claims on the same income as “juridical double
taxation”.
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Example
Assume that Hank Jones (a U.S. citizen), an entertainer, is a resident of England and a non-resident of
Canada. He performs in Canada for FC, a foreign corporation incorporated and resident in England.
Jones is paid $100,000 for his performances from a bank account maintained in England. Jones could
potentially be liable for tax in three countries: for Canadian income tax as a non-resident if he is
considered to be “employed in Canada”; for tax in England on the basis of his residence in that country;
and in the U.S. on the basis of his citizenship. Tax treaties attempt to resolve such difficulties.
a.
Nature and Purpose of DTCs
A DTC is a bilateral agreement between two sovereign states: 41
[…] an international agreement concluded between States in written form and governed by
international law, whether embodied in a single instrument or in two or more related instruments and
whatever its particular designation.
Treaties do not impose taxes; they merely limit taxing powers. Although tax treaties may reduce a
taxpayer’s domestic tax, they do not generally increase taxes. This is clearly the majority view of
countries. 42 For example, a tax treaty between two countries might limit the maximum withholding tax
by the source country on interest payments to 10%. That does not mean, however, that the treaty
partners must impose any tax on interest payments to non-residents.
There is a difference, however, between treaties not imposing taxes and a taxpayer being subjected to
taxation because the treaty does not address the particular source of income. For example, there is no
U.S. withholding tax under the Canada – US Treaty on dividends paid to a Canadian Registered
Retirement Savings Plan (RRSP) because it provides tax-deferred pension or retirement benefits. The
treaty provision does not apply to Tax Free Savings Accounts (TFSAs), which do not come within the
definition. Hence, there is a 15% (30% without a W-8BEN form filed with the IRS) withholding tax on
dividends paid to a TFSA. Since, TFSA earnings are not taxable, the withholding tax cannot be claimed
as a tax credit against its income. Thus, although TFSAs are non-taxable in Canada, their foreign
investment income can be subject to foreign taxes without any domestic relief.
b.
Allocation of Taxing Jurisdiction
Regardless of the particular Model used in negotiations, all DTCs focus on the prevention of juridical
double taxation of income by allocating jurisdiction to tax to the Contracting States or by stipulating
agreed upon source rules and maximum tax rates. Such a system promotes trade co-operation
between countries by fostering an atmosphere of fiscal certainty in international transactions.
The Models use a “classify and assign” system to allocate jurisdiction to tax. For example, a Model may
assign the exclusive right to tax to one of the Contracting States by stating that the income “shall be
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taxable only” in that State. The exclusive allocation prevents double taxation by precluding the other
country from imposing any tax on the particular income.
The OECD Model generally assigns the exclusive right to tax income to the country of the taxpayer's
residence. Alternatively, the Model may assign the exclusive right to tax to the source country of
income even if the taxpayer does not reside therein.
In some cases, the jurisdictional right to tax is not exclusive and the provision will provide that the
income in question “may be taxed” in the source country or the country in which the taxpayer has a
permanent establishment or fixed base. In these cases, the country of residence is required to avoid
double taxation by providing either a deduction from income or a credit against taxes payable.
Two states may tax a person who is not a resident of either country on income derived from, or capital
owned in, one of the states. For example, a person resident in State R may have a permanent
establishment in State E. If the person derives income from, or owns capital in, State S, he does not
come within the “Personal Scope” of any Model Treaty, which apply only to persons who are residents
of one or both of the Contracting States. The OECD Model does not address this type of situation.
Thus, juridical double taxation should occur only if the applicable treaty permits both countries to tax a
particular item of income or capital. There can be no double taxation if the treaty gives the exclusive
right to tax to either the country of residence or the country of source. Where a treaty gives both the
country of source and the country of residence the right to tax a particular item of income or capital,
the country of source has the prior right to tax. The country of residence must take into account the
tax paid in the source country and provide relief to avoid double taxation.
c.
Enforcement of Treaties
The enforcement of treaties depends upon the constitutional structure of the participating country.
Under Canadian constitutional law and tradition, for example, Parliament has the sole authority to levy
taxes. Canada enacts its tax treaties through legislation into its domestic law. Thus, its international
tax treaties are part of Canadian law and disputes arising under any treaty are litigated in the federal
tax courts. In theory, Canada could indirectly levy taxes through a treaty and then enact the taxes by
adopting the treaty as part of domestic law through its normal constitutional processes. In fact, Canada
has never done so.
Similarly, the United Kingdom limits taxing powers to its Parliament. The U.K. Bill of Rights of 1688
provides:
That levying money for or to the use of the Crown by pretence of prerogative without grant of
Parliament for longer time or in other manner than the same is or shall be granted is illegal. 43
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d.
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Treaty Shopping
The Commentary to the OECD Model states the purpose of DTCs: “The principal purpose of double
taxation conventions is to promote, by eliminating international double taxation, exchanges of goods
and services, and the movement of capital and persons. It is also a purpose of tax conventions to
prevent tax avoidance and evasion.” 44 However, taxpayers can use DTCs to avoid tax by treaty
shopping for low tax rate countries. For example, taxpayers can exploit differential tax rates between
countries, or channel specific sources of income to particular jurisdictions, in order to minimize
withholding taxes. They may also interpose artificial entities between countries to take advantage of
different domestic laws in each of the countries. Hence, a treaty designed to prevent double taxation
can be a vehicle for tax avoidance.
There are two basic approaches to counter tax avoidance: domestic legislation (such as the general
anti-avoidance rule) 45 and specifically negotiated anti-avoidance or anti-treaty shopping provisions
within the DTC itself (such as limitation of benefits or abuse of law rules). The interplay between these
two mechanisms can cause interpretational difficulties and inconsistencies.
Paragraphs 6.1, 7, and 8 of the OECD Commentary address some of the difficult issues associated with
the use of domestic rules concerning treaty shopping in negotiating treaties.
“Taxpayers may be tempted to abuse the tax laws of a State by exploiting the differences between
various countries’ laws. Such attempts may be countered by provisions or jurisprudential rules that are
part of the domestic law of the State concerned. Such a State is then unlikely to agree to provisions of
bilateral double taxation conventions that would have the effect of allowing abusive transactions that
would otherwise be prevented by the provisions and rules of this kind contained in its domestic law.
Also, it will not wish to apply its bilateral conventions in a way that would have that effect.
It is also important to note that the extension of double taxation conventions increases the risk of
abuse by facilitating the use of artificial legal constructions aimed at securing the benefits of both the
tax advantages available under certain domestic laws and the reliefs from tax provided for in double
taxation conventions.
This would be the case, for example, if a person (whether or not a resident of a Contracting State), acts
through a legal entity created in a State essentially to obtain treaty benefits that would not be
available directly. Another case would be an individual who has in a Contracting State both his
permanent home and all his economic interests, including a substantial shareholding in a company of
that State, and who, essentially in order to sell the shares and escape taxation in that State on the
capital gains from the alienation (by virtue of paragraph 5 of Article 13), transfers his permanent home
to the other Contracting State, where such gains are subject to little or no tax.”
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e.
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Treaty Override
The doctrine of “treaty override” refers to the status of subsequently enacted domestic legislation
conflicting with obligations undertaken in a treaty. As a general principle of international law, a State
should not legislate in breach of its own international obligations. Article 60 of the Vienna Convention
provides, for example, that a material breach of a treaty is grounds to terminate the treaty. Article 60(3)
defines a “material breach” as a repudiation of the treaty or the violation of one of its essential
provisions. Article 27 states that “a party may not invoke the provisions of its internal law as
justification for its failure to perform a treaty….”
Countries adopt different approaches to the status of treaty override under international law. For
example, a country can constitutionally entrench treaty supremacy into its law. Or, at a lower level, it
can enact enabling legislation that incorporates the treaty into domestic law and stipulate that the
treaty stands superior in event of conflict between domestic law and treaty provisions. Some
countries, for example, the United Kingdom, operate on a presumption in favour of the treaty unless
there is a clear intention to override it. 46
The United States has a constitutionally entrenched treaty override power and has not ratified the
Vienna Convention on Treaties. Thus, generally, the relationship between its treaty and statute law is
determined by the ordinary rules of interpreting laws of equal dignity. For example, section 7852(d) of
the Internal Revenue Code (IRC) states the status of US treaty obligations:
“(1) In general
For purposes of determining the relationship between a provision of a treaty and any law of the United
States affecting revenue, neither the treaty nor the law shall have preferential status by reason of its
being a treaty or law.
(2) Savings clause for 1954 treaties
No provision of this title (as in effect without regard to any amendment thereto enacted after August
16, 1954) shall apply in any case where its application would be contrary to any treaty obligation of the
United States in effect on August 16, 1954.”
Examples of Override by U.S:


Foreign Investment in Real Property Act (FIRPTA) of 1980 — Act provided that after five years it
would apply without regard to any relief provided by treaty;
Branch Profits Tax 47.
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f.
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Arm’s Length Principles
A fundamental principle underlying treaties is that the income of non-residents should be allocated to
countries on the basis of “arm’s length principles”. This implies that the taxable profits of a business
enterprise, whether operated in a particular country through a subsidiary or a branch, will be subject
to tax as if the enterprise conducted its business independently in that country.
Similarly, it is assumed for most treaty purposes that products purchased by a business enterprise from
related parties (for example, by a subsidiary from its parent corporation) should be priced as if the
products were purchased from an unrelated third party.
The arm’s length principle implies that a country should assess non-residents and foreign income only
in respect of income that arises in the country. Although the method by which a country determines
foreign income may refer to a formula, the jurisdiction to tax the taxpayer rests on the arm’s length
principle. The formula, if any, merely facilitates the calculation of income to reasonably approximate
the amount that the country would arrive at in an arm’s length calculation.
Thus, both the jurisdiction to tax the business enterprise and the prices at which it is presumed to
transact with related parties are premised on the notion that the enterprise operates on an arm’s
length and independent basis. These concepts are the heart of transfer pricing between related
parties. Transfer pricing is one of the major causes of tax disputes and litigation, which can stretch for
years. Transfer pricing is also one of the most lucrative forms of tax avoidance by multinationals.
Professor Vern Krishna, CM, QC, FRSC
University of Ottawa Law School,
Tax Counsel, Tax Chambers LLP (Toronto)
[email protected]
www.vernkrishna.com
1
See, for example, Holman v. Johnson, 98 Eng. Rep. 1120, 1121 (K.B. 1775) (Lord Mansfield) (“For no country
ever takes notice of the revenue laws of another.”); Planche v. Fletcher, 99 Eng. Rep. 164, 165 (K.B. 1779) (Lord
Mansfield) (“One nation does not take notice of the revenue laws of another.”).
2
Moore v. Mitchell, 30 F.2d 600, 604 (2d Cir. 1929) (L. Hand, J., concurring).
3
[1955] A.C. 491.
4
[1928] Ch. 877 at 884.
5
See Convention with Respect to Taxes on Income and on Capital, Mar. 28, 1984, U.S.-Canada, arts. XXVI & XXVII,
T.I.A.S. No. 11087 (entered into force Aug. 16, 1984); see also Taxation Comm. Staff Explanation of Canada-U.S.
Protocol, at 41-42.
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6
See United States of America v. Harden [1963] SCR 366. See also: Her Majesty the Queen in Right of the Province of
British Columbia v. Gilbertson, 597 F.2d 1161, 1165 (9th Cir. 1979) (“If the court below was compelled to recognize
the tax judgment from a foreign nation, it would have the effect of furthering the governmental interests of a foreign
country, something which our courts customarily refuse to do.”); Banco Frances e Brasileiro S.A. v. Doe, 36 N.Y.2d
592, 601-02, 370 N.Y.S.2d 534, 331 N.E.2d 502 (1975) (Wachtler, J., dissenting) (“Under the principle of territorial
supremacy, fundamental to the community of nations, courts refuse to enforce any claim which in their view is a
manifestation of a foreign State’s sovereign authority.”); QRS 1 APS v. Frandsen, 1999 3 All E.R. 289, 294-97 (C.A.)
(denying letters rogatory in connection with a tax claim under the revenue rule because “it may be considered that
this line of thinking is obsolete, but it still remains anchored within us that we will not permit the presence in our
country of foreign tax men, even if represented by intermediaries; we do not tolerate that any help may be given to
them” (quoting Professor Mazeaud’s commentary on the French court decision Bemberg v. Fisc de la Provincia de
Buenos Aires (Feb. 24, 1949) (unreported)); Taylor, [1955] A.C. at 511 (“[A] claim for taxes is but an extension of the
sovereign power which imposed the taxes, and . . . an assertion of sovereign authority by one State within the
territory of another . . . is (treaty or convention apart) contrary to all concepts of independent sovereignties.”); In re
Guyana Dev. Corp., 201 B.R. 462, 473-74 & n.4 (Bankr. S.D. Tx. 1996) (describing difficulty encountered by estate
trustee in obtaining property overseas because foreign countries perceived trustee as IRS surrogate).
7
S. Rep. No. 91-617, at 76 (1969); see Statement of Findings and Purpose, Organized Crime Control Act of 1970, Pub.
L. 91-452, 84 Stat. 922, 922-23 (1970). “RICO provides that ‘any person injured in his business or property by reason
of’ a RICO violation may bring a civil action to recover treble damages.”
8
For example, see: “The Economist Explains: What’s Driving American Firms Overseas?”, The Economist (16 August
2015), online: http://www.economist.com/blogs/economist-explains/2015/08/economist-explains-9.
9
See, for example, ibid., s. 126 (foreign tax deduction).
10
See, for example, the Canada Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), s. 149(1)(a) (employees of foreign
governments).
11
See, for example, section 902 of the United States Internal Revenue Code [hereinafter IRC].
12
See, generally, section 126.
13
See, for example, Articles X, XI, and XII of the Canada – U.S. Convention.
14
United States: Staff of the Joint Committee on Internal Revenue Taxation, Legislative History of United States
Conventions, Vol. 4, Model Tax Conventions (Washington DC: US Government Printing Office, 1962), p. 4003.
15
Article 2(1)(a), Vienna Convention on the Law of Treaties (“Vienna Convention”), UN Doc. A/CONF. 39/27 (1969).
16
United States: Staff of the Joint Committee on Internal Revenue Taxation, Legislative History of United States
Conventions, Vol. 4, Model Tax Conventions (Washington DC: US Government Printing Office, 1962), p. 4003.
17
Report of the Secretary General, United Nations Economic and Social Council, “Eight Meeting of the Ad Hoc Group
of Experts on International Co-operation in Tax Matters”, July 1998.
18
Introduction, UN Commentary, paras. 1 and 2.
19
See, for example, Beame v. R., [2004] F.C.J. No. 237, 2 C.T.C. 265.
20
Article 26, The Vienna Convention, ante, “Every treaty in force is binding upon the parties to it and must be
performed by them in good faith.”
21
This is clearly the majority view of countries. See, for example, the decision of the French Conseil d’Etat, June 6,
1984 (1984) 36 Droit Fiscal 48 at 1436 discussed in (1985) E.T. 233 (“Since the main purpose of a bilateral convention
is to prevent double taxation, it may in a given case exempt a taxpayer from the tax to which he normally would have
been subject. However, it cannot make him subject to tax in a State where he would not have been subject by view of
an internal criterion regarding the scope of the tax,…”).
22
See, for example, Hausmann Estate v. The Queen [1998] 4 C.T.C. 2232 (TCC – (IT)) (pension payment was found to
be not taxable in either jurisdiction).
23
Matthews v. Chicory Marketing Board (VIC) (1938) 60 C.L.R. 263 (HCA).
24
Re Eurig Estate, [1998] 2 S.C.R. 565, [2000] 1 C.T.C. 284 (S.C.C.).
25
Meriwether v. Garrett, 102 U.S. 472, 514 (1880)
26
United States v. Reorganized CF&I Fabricators of Utah, Inc., 518 U. S. 213, 224 (1996); see also United States v. La
Franca, 282 U.S. 568, 572 (1931) (“[A] penalty, as the word is here used, is an exaction imposed by statute as
punishment for an unlawful act”).
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MADRID 2016
27
Compania General de Tabacos de Filipinas v. Collector of Internal Revenue, 275 U.S. 87, 100 (1927) (Holmes J.
dissenting).
28
See Explanation of U.S. Model Convention.
29
See also, A-G v. Wiltshire United Dairies (1921), 37 T.L.R. 884.
30
Report of the Secretary General, United Nations Economic and Social Council, “Eight Meeting of the Ad Hoc Group
of Experts on International Co-operation in Tax Matters,” July 1998.
31
Introduction, UN Commentary, paras. 1 and 2.
32
See: Council Directive 90/435/EEC (July 23, 1990).
33
Also known as double tax agreements (DTAs) because they seek to prevent double taxation of income.
34
Report on Double Taxation submitted to the Financial Committee by Professors Bivens, Einavai, Seligman and
Stamp at 18 League of Nations, Doc. EFS 73 F19 (1923).
35
See, for example, Article 6, OECD Model and Canada-UK Treaty.
36
See ss.212(2), Income Tax Act.
37
See, for example, Article 10, Canada-UK Income Tax Convention.
38
See “Tax Sparing.”
39
See section 245, Income Tax Act (Canada).
40
Section 245.
41
Article 2(1)(a), Vienna Convention on the Law of Treaties (“Vienna Convention”), UN Doc. A/CONF. 39/27 (1969).
42
See, for example, the decision of the French Conseil d’Etat, June 6, 1984 (1984) 36 Droit Fiscal 48 at 1436 discussed
in (1985) E.T. 233 (“Since the main purpose of a bilateral convention is to prevent double taxation, it may in a given
case exempt a taxpayer from the tax to which he normally would have been subject. However, it cannot make him
subject to tax in a State where he would not have been subject by view of an internal criterion regarding the scope of
the tax,…”)
43
See also, A-G v. Wiltshire United Dairies (1921), 37 TLR 884.
44
See para. 6 OECD Commentary: “Improper use of the Convention”.
45
See s. 245 of the Income Tax Act.
46
See: IRC v. Collco Dealings Ltd. (1961), 39 T.C. 509 (H.L.) (Legislation enacted in 1955 applied to a company resident in
Ireland despite earlier exemptions in tax treaties of 1926 and 1947 Treaties for Irish residents. Generally, statutes should
not abrogate international obligations but the wording of the 1955 enactment was unambiguous and prevailed over the
treaty.)
See also: Woodend (K.V. Ceylon) Rubber & Tea Co. Ltd. v. CIR, [1971] A.C. 321 (P.C.) (1959 UK legislation imposing 33
1/3 per cent tax on non-residents conflicted with the non-discrimination clause in Article XVIII of Tax Treaty. Domestic
legislation prevailed because language was clear and did not exclude non-residents of treaty country.)
47
Section 884(a) of the IRC.
41