The Relationship among Articles 6, 7, 13 and 21 of the OECD Model
Adv LLM thesis
submitted by
Jaehee Han
in fulfilment of the requirements of the
'Advanced Master of Laws in International Tax Law'
degree at the University of Amsterdam
supervised by
Otto Marres
PERSONAL STATEMENT
Regarding the Adv LLM Thesis submitted to satisfy the requirements of the 'Advanced Master of Laws in International Tax Law' degree:
1. I hereby certify (a) that this is an original work that has been entirely prepared and written by myself
without any assistance, (b) that this thesis does not contain any materials from other sources unless these sources have been clearly identified in footnotes, and (c) that all quotations and paraphrases have been properly marked as such while full attribution has been made to the authors thereof. I accept that any violation of this certification will result in my expulsion from the Adv LLM Program or in a revocation of my Adv LLM degree. I also accept that in case of such a violation professional organizations in my home country and in countries where I may work as a tax professional, are informed of this violation.
2. I hereby authorize the University of Amsterdam and IBFD to place my thesis, of which I retain the
copyright, in its library or other repository for the use of visitors to and/or staff of said library or other repository. Access shall include, but not be limited to, the hard copy of the thesis and its digital format.
3. In articles that I may publish on the basis of my Adv LLM Thesis, I will include the following statement in
a footnote to the article’s title or to the author’s name:
“This article is based on the Adv LLM thesis the author submitted in fulfilment of the requirements of the 'Advanced Master of Laws in International Tax Law' degree at the University of Amsterdam.”
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other university or institution is identified in the text. I accept that any violation of this certification will result in my expulsion from the Adv LLM Program or in a revocation of my Adv LLM degree.
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name: Jaehee Han
Jaehee Han version 13 07 2020 III
Table of Contents
Table of Contents ... III
List of Abbreviations used ... IV
Executive Summary ... V
Main Findings ... VI
1.
Introduction ... 1
1.1. A triangular case including overlap and mismatch issues ... 1
1.2. Two legal issues derived from the priority rules of the OECD Model ... 1
1.2.1. Applicable tax treaties ... 1
1.2.2. Related priority rules ... 1
1.2.3. First issue: income from immovable property - Art. 7 or 21(1)? ... 2
1.2.4. Second issue: capital gain - Art. 13(5) ... 2
1.3. The purpose and order of this article ... 2
2.
The position of the OECD ... 3
2.1. Income from immovable property: Art. 21(1) applies ... 3
2.2. Capital gain: Art. 13(5) applies ... 3
2.3. The OECD's expected answer for the case ... 4
3.
Legal background and analysis of the OECD position ... 4
3.1. Legal background ... 4
3.1.1. The cause of overlap and mismatch/conflict subject to individual domestic law ... 5
3.1.2. When is source state’s taxation not in accordance with priority rule of tax treaties? ... 8
3.1.3. Intermediate conclusion ... 12
3.2. Analysis of the OECD position ... 12
3.2.1. PE triangular cases: The case is “Residence-Source-Source” Triangular Case ... 12
3.2.2. Income from immovable property in the case ... 13
3.2.3. Capital gain in the case ... 13
3.2.4. Double tax relief in case State PE taxes income or capital gain as business profits . 14
4.
Possible solutions ... 14
4.1. Policy Considerations ... 14
4.1.1. Situs principle ... 14
4.1.2. Two possible solutions from a policy perspective ... 15
4.1.3. The author's assessment ... 16
4.2. Technical amendment for clarification ... 18
5.
Conclusion ... 18
List of Abbreviations used
Art., Arts. Article, Articles
MAP Mutual Agreement Procedure Para. Paragraph
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Executive Summary
Here is a PE triangular case including overlap and mismatch issues:
An enterprise resident in State R mainly runs a rental/trading business of immovable property situated in States S held through (attributable to) a branch office in State PE. In case that State PE taxes the income or gain from the business classifing it as business profits, should State R give double tax relief for the tax levied by State PE?
The relationship between business profit and income from immovable property is not new and that between business profit and capital gain seems indisputable under the OECD Model. Nevertheless, in case that State PE taxes the income/gain as business profits in the PE triangular case with immovable property, the issue would become slightly different and two issues can be generated:
1) Whether State R should give double tax relief if the legitimacy of State PE’s taxation is debatable. 2) When the priority rule of tax treaties is applied in the context of double tax relief.
In the author’s interpretive viewpoint, State R should not give double tax relief in the case of income from immovable property while State R should do in the case of capital gain even though the OECD approach, which might not give double tax relief in both cases, seems understandable from a policy viewpoint. In the course of deducting this conclusion, there are two noteworthy arguments found:
1) In case that the allocation of taxing rights through the priority rule of a tax treaty leads to giving exclusive taxing rights, to one of the contracting states (mainly residence state), the domestic law of the other contracting state (mainly source state) cannot put back the outcome decided by the priority rule of tax treaties. Other than this case, source state’s income classification should be respected by residence state.
2) It is inappropriate residence state does not give double tax relief if the legitimacy of source state’s taxation is debatable even though the position of the OECD Commentary is obvious.
In the author’s policy viewpoint, it seems difficult to change the situs and symmetry principle deeply embodied in the OECD Model about the allocation of taxing rights on immovable property. Nevertheless, the case of income from immovable property situated in a residence state or a third state should be solved more clearly to adopt the OECD perspective, which has still been provided in the OECD Commentary, into the provision of the OECD Model Tax Convention.
Main Findings
1. Arts. 6 and 13 takes precedence over Art. 7.
2. In case of immovable property situated in a residence state or a third state, the matter of allocating taxing rights between the residence state and the PE state is debatable regarding income from immovable property, but is indisputable regarding capital gain
A. The OECD perspective is to allocate taxing rights exclusively to residence state, emphasizing the situs and symmetry principle.
B. In the author’s opinion, it is inappropriate residence state does not give double tax relief if the legitimacy of source state’s taxation is debatable even though the position of the OECD Commentary is obvious.
3. In case that the allocation of taxing rights through the priority rule of a tax treaty leads to giving exclusive taxing rights, to one of the contracting states (mainly residence state), the domestic law of the other contracting state (mainly source state) cannot put back the outcome decided by the priority rule of tax treaties. Other than this case, source state’s income classification should be respected by residence state.
A. South Korea and Japan tried to solve the issue of income qualification conflicts by revising domestic law, but have not still found the clear-cut answer.
4. It seems difficult to change the situs and symmetry principle deeply embodied in the OECD Model about the allocation of taxing rights on immovable property.
A. This is due to the repulsion against foreign passive investment and tax avoidance matter. 5. Although there can be several ways to adopt the OECD position, it is necessary to clarify the
case of income from immovable property.
A. For example, the provision may stipulate that “Income from immovable property other than that referred to in paragraph 1 shall be applied to Article 21”.
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1. Introduction
1.1. A triangular case including overlap and mismatch issues
Here is a PE triangular case including overlap and mismatch issues (Hereinafter “the case”):
An enterprise resident in State R mainly runs a rental/trading business of immovable property situated in States S held through (attributable to) a branch office in State PE. In case that State PE taxes the income or gain from the business classifing it as business profits, should State R give double tax relief for the tax levied by State PE?
There are two assumptions in the case: The first is that State R treats it as incom from immovable property or capital gains, and the second is that there is no PE of the enterprise in State S. Also, it should be noted that the reason that bringing a rental/trading business of immovable property is to show the income in the case is an obvious overlap between “business profit” and “income from immovable property”/”capital gain”.
1.2. Two legal issues derived from the priority rules of the OECD Model
Before discussing double tax relief, it is necessary to look into the allocation of taxing rights, which explains which country can tax the income or gain, under the OECD Model because the relief can be granted only in case that taxation in the other Contracting State is in accordance with the provisions of the tax treaty. Hence, we need to look at some articles in the OECD Model and the relationships among those articles after explaining the applicable tax treaties in the case.
1.2.1. Applicable tax treaties
Assuming that the three states have concluded tax treaties that follows the OECD Model 2017 in all material respects, the applicable treaties in the case are:
- the treaty between State R and State PE (the “R-PE treaty”); and - the treaty between State R and State S (the “R-S treaty”)
First, the legal effect according to the R-S treaty is quite simple. If State S levies taxes on the rental/trading income, it is obvious for State R to give double tax relief for the tax levied by State S because State S’s taxation may be in accordance with Arts. 6, 7 and 13 under the OECD Model as explained in detail below.
Second, the treaty which this article focuses on is the R-PE treaty. If State PE is allowed to tax the income in the case, there can be a triple taxation and State R Shall give double tax relief twice in the case of immovable property situated in State S.
1.2.2. Related priority rules
There are two priority provisions, which are Arts. 6(4) and 7(4) of the OECD Model1 regarding this issue:
1 Hereinafter, OECD Model means 2017 version of “Model Tax Convention on Income and on Capital” updated
ARTICLE 6 (INCOME FROM IMMOVABLE PROPERTY) 4. The provisions of paragraphs 1 and 3
shall also apply to the income from immovable property of an enterprise.
ARTICLE 7 (BUSINESS PROFITS) 4. Where profits include items of income which are dealt with
separately in other Articles of this Convention, then the provisions of those Articles shall not be affected by the provisions of this Article.
1.2.3. First issue: income from immovable property - Art. 7 or 21(1)2?
Both Arts. 6 and 7 indicate Art. 6(1)3 takes precedence over Art. 7 in common. The relationship
between two provisions is disputable. Brian Arnold finds Art. 6(4) unnecessary, given that Art. 7(4) has already provided for the priority to Art. 6 in case of overlap.4 On the other hand, Dhruv Sanghavi
argues Art. 6(4) cannot be relied on to oust income from immovable property from the scope of Art. 7 in favour of Art. 21.5
The reason Dhruv mentions Art. 21 is that Art. 6 is not applied to income from immovable property situated in the residence state or a third state6 even in case the income is not overlapped with
business profits. Then, the issue is whether the case of rental income should remain at Art. 7 or move to Art. 21 unless Art. 6 is applicable.
1.2.4. Second issue: capital gain – Art. 13(5)
Also regarding capital gains, Art. 13(1) 7 states that gains from the alienation of immovable property
may be taxed in the State in which it is situated. It does not, therfore, apply to gains derived from the alienation of immovable property situated in State R or S.In this case, Art. 13(2)8 seems to have a
different scope than Art. 7 where it only covers movable property. So capital gains not covered by Art. 13(1) would be covered by Art. 13(5),9 including the case of immovable property would be part of the
PE assets.
1.3. The purpose and order of this article
The relationship between business profit and income from immovable property is not new and that between business profit and capital gain seems indisputable under the OECD Model. Nevertheless, in case that State PE taxes the income/gain as business profits in the PE triangular case with immovable property, the issue would become slightly different and two issues can be generated:
1) Whether State R should give double tax relief if the legitimacy of State PE’s taxation is debatable.
2) When the priority rule of tax treaties is applied in the context of double tax relief.
2 Art. 21(1) provides that “Items of income of a resident of a Contracting State, wherever arising, not dealt with
in the foregoing Articles of this Convention shall be taxable only in that State”.
3 Art. 6(1) provides that “Income derived by a resident of a Contracting State from immovable property
(including income from agriculture or forestry) situated in the other Contracting State may be taxed in that other State”.
4 Arnold, Brian J., ‘Article 5: Permanent Establishment’, Global Tax Treaty Commentaries (2018), IBFD, p.6. 5 Sanghavi, Dhruv, ‘The interaction of Articles 6, 7 and 21 of the 2014 OECD Motel Tax Convention: A Historical
Analysis’, 44 Intertax 8/9 651 (2016), p.656.
6 Para. 1 of OECD Commentary on Art. 6.
7 Art. 13(1) stipulates that “Gains derived by a resident of a Contracting State from the alienation of immovable
property referred to in Article 6 and situated in the other Contracting State may be taxed in that other State”.
8 Art. 13(2) provides that “Gains from the alienation of movable property forming part of the business property of
a permanent establishment which an enterprise of a Contracting State has in the other Contracting State, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise), may be taxed in that other State.”
9 Art. 13(5) stipulates that “Gains from the alienation of any property, other than that referred to in paragraphs 1,
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After the introduction, Chapter 2 briefly summarizes the OECD position in the case. Chapter 3 analyzes the OECD apprach after discribing the legal background of the analysis with a short glance at Japanese and Korean domestic law provisions. Chapter 4 introduces policy considerations and technical amendments for the clarification. Chapter 5 makes a short conclusion of this article.
2. The position of the OECD
It must be important to understand the approach of the OECD Commentary on the case. The answer lies a little scattered under the Commentary and is relatively simple without precise reasoning. We will look at it deviding into “income from immovable property”(Art. 6) and “gains from the alienation of immovable property”(Art. 13).
2.1. Income from immovable property: Art. 21(1) applies – Exclusive taxing right to State R
The OECD Commentary supports the view that Art. 21(1) under the R-PE treaty, rather than Art. 7, shall apply in the case of income from immovable property situated in State R. This solution is explained in para. 4 of the OECD Commentary on Art. 21(2)10 and para. 9 of it on Arts. 23A and 23B,
which read in relevant part as follows:
[para. 4 of the Commentary on Art. 21(2)] Immovable property situated in a Contracting State
and forming part of the business property of a permanent establishment of an enterprise of that State situated in the other Contracting State shall be taxable only in the first-mentioned State in which the property is situated and of which the recipient of the income is a resident. This is in consistency with the rules laid down in Articles 13 and 22 in respect of immovable property since paragraph 2 of those Articles applies only to movable property of a permanent establishment.
[para. 9 of the Commentary on Arts. 23A and 23B] Where a resident of the Contracting State
R derives income from the same State R through a permanent establishment which he has in the other Contracting State E, State E may tax such income (except income from immovable property situated in State R) if it is attributable to the said permanent establishment.
There is also some reinforcement in the OECD Commentary that Art. 21(1) under the R-PE treaty applies in the case of income from immovable property situated in State S. See para. 10 of the OECD Commentary on Arts. 23A and 23B, which explains in related part as follows:
Where a resident of State R derives income from a third State through a permanent
establishment which he has in State E, such State E may tax such income (except income from immovable property situated in the third State) if it is attributable to such permanent
establishment.
To sum up, the OECD provides that the exclusive taxing right should be granted to State R in the case of income from immovable property situated in State R or S according to Art. 21(1) under the R-PE treaty even though the rental business is held through (attributable to) a branch office in State PE.
2.2. Capital gain: Art. 13(5) applies – Exclusive taxing right to State R
The OECD Commentary does not mention explicitly the solution in the case of capital gain. Although
10 Art. 21(2) provides that “The provisions of paragraph 1 shall not apply to income, other than income from
immovable property as defined in paragraph 2 of Article 6, if the recipient of such income, being a resident of a Contracting State, carries on business in the other Contracting State through a permanent establishment situated therein and the right or property in respect of which the income is paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply”.
the Commentary provids Art. 13(1) applies also to immovable property forming part of the assets of an enterprise,11 it is not enough to solve the case because it is not provided if the income is active.12
However, the OECD perspective seems obvious that Art. 13(5) should apply. As shown above in para. 4 of the OECD Commentary on Art. 21(2), the OECD Commentary emphasizes the consistency among Arts 6, 13 and 22 assuming that Arts. 13(5) and 22(5) should apply in the case. To be specific, the OECD Commentary provides that the outcome of the case of imcome from immovable property should be in consistency with the rules laid down in Arts. 13 and 22 in respect of immovable property since para. 2 of those Articles applies only to movable property of a PE.
Focusing on Art. 13, Art. 13(2)13 has a different scope than Art. 7 where it only covers movable
property. So capital gains not covered by Art. 13(1), i.e. gains derived from the alienation of
immovable property situated in State R or State S, would be covered by Article 13(5), even where the immovable property would be used as business assets attributable to a PE in PE State. Hence, OECD views the exclusive taxing right should be given to State R between States R and PE in the case of capital gain.
2.3. The OECD’s expected answer for the case
The OECD might see State R is not required to give double tax relief to taxpayers in the case. This is because State PE does not follow the OECD direction even though the qualification mismatch is derived from the different classification pursuant to each country’s domestic law. In other words, it seems State PE misinterprets tax treaty and their taxation is not in accordance with the treaty from the OECD perspective. When it comes to Art. 6, some author also argues that the ‘context’ within the meaning of Art. 3(2) of the R-PE tax treaty – including Art. 21(2) of the treaty – prevents State PE from categorizing the income under Art. 7 of the treaty, regardless of its domestic law classification of the income as business profits.14
3. Legal background and analysis of the OECD position
3.1. Legal background
The approach of the OECD Commentaries is sensible from a policy perspective.15 It is true that this
prevents triple taxation and the potential for unrelieved double taxation, because the income would only be taxed in the state where the immovable property is situated and the residence state, with relief being provided in the residence state (either by way of exemption or credit).16 Furthermore, they put
much value on situs principle, which is the situs state has priority in taxing the income from immovable property and the immovable property itself.1718
11 Para. 22 of OECD Commentary on Art. 13(1).
12 “immovable property forming part of the assets of an enterprise” can differ from the immovable property used
in real property trading business.
13 Art. 13(2) provides that “Gains from the alienation of movable property forming part of the business property of
a permanent establishment which an enterprise of a Contracting State has in the other Contracting State, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise), may be taxed in that other State”.
14 Bosman, Alexander, ‘Redefining the Relation Between Articles 6, 7 and 21 of the OECD Model’, Intertax
Volume 45 Issue 1 (2017), p.48.
15 Raad, Kees van and Chen, Shaomei, ‘Triangualar Cases – Global Tax Treaties Commentaries’, IBFD, 2019,
section 4.2.1.2.2.
16 Fett, Emily, ‘Triangular Cases - The Application of Bilateral Income Tax Treaties in Multilateral Situations’, Vol.
29 IBFD Doctoral Series, Ch. 2.6.4.
17 Rust, Alexander, ‘Situs Principle v. Permanent Establishment Principle in International Tax Law’, BULLETIN -
TAX TREATY MONITOR Volume 56(No.1), 2002, p.15.
18 Pijl, Hans calls this kind of argument as a “Principle of Symmetry”[‘Capital Gains: The History of the Principle
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Chapter 3 tries to explain more precisely the basis upon which the OECD’s conclusion is reached. The case can be called as “overlap”, “qualification mismatch” and “triangular” cases. The following section analyses, firstly, 3.1.1. The cause of overlap and mismatch/conflict subject to individual domestic law and, secondly, describes the implication of the OECD position.
3.1.1. The cause of overlap and mismatch/conflict subject to individual domestic law
3.1.1.1. The cause of overlap
The overlap of income classification often takes place under scheduler income taxation system dividing incomes into active business income and passive income.
3.1.1.1.1. Scheduler system and other income19
Countries with a scheduler definition of income often provide different rules for determining the amount of taxable income in different categories of income, including different rules for methods of accounting and allowable deductions, and exempt amounts for different categories. Within the group of countries providing a scheduler definition of income, one can draw distinctions among countries according to the comprehensiveness of the definition of income. A common technique is to define income according to various categories, but then to provide that “other income” falls into a residual category.
3.1.1.1.2. Foreign source active and passive income20
Corporations generate income from a range of activities and sources. Broadly, income can be
classified as active or passive. Active income normally arises from the primary business activity of the company and involves more than investing in an asset that generates a return. It often involves a continuous process of designing, producing and selling a good or service to ultimate customers, whether related or unrelated to the company.
Passive income normally is generated by the corporation through acquiring and holding the asset with no additional activity, again regardless of whether the income is received from a related or unrelated party. While the precise definition of passive income differs between countries, interest income, royalty payments from owning intellectual property, dividends from holding shares, and rental income often are classified as passive income. Capital gains realized from the sale of assets that generate passive income (e.g., shares, loans, intellectual property, or buildings) may be considered passive income.
A determination of the existence of passive income may depend on the business activities of a particular corporation. For example, rental income for a company that builds, owns, and operates shopping centres normally would not be passive income. Furthermore, interest income generated by a bank would not be considered passive as such entities are in the business of borrowing and lending money. In principle, the distinction between active business income and passive income should be how much requires human activity, not the property itself is the primary subject matter of the underlying transaction.21 Of course, it would not be simply to decide what is human activity, either.
Commentary on “Forming Part” and “Effectively Connected”’, World Tax Journal (2013) (Volume 5), No. 1].
19 This section is quoted from Victor Thuronyi, Kim Brooks and Borbala Kolozs, Comparative Tax Law(second
edition), Wolters Kluwer, 2016, p. 212.
20 This section except for last two sentences is quoted from PricewaterhouseCoopers LLP, ‘A Comparison of
Key Aspects of the International Tax Systems of Major OECD and Developing Countries’
(https://s3.amazonaws.com/brt.org/archive/BRT_14_country_international_tax_comparison_20100510.pdf, last assessed on 10 June 2020), 2010, p.4.
21 Becker, Adam, ‘International - The Principle of Territoriality and Corporate Income Taxation – Part 1 What
3.1.1.2. The cause of mismatch or conflict: domestic law treatment
The mismatch or conflict of income classification between two countries also occurs in this regard. In the absence of any applicable treaty limitations, all three states involved in a PE triangular case may seek to impose tax on the income in accordance with the provisions of their respective domestic laws.22 This is a result of the application of the residence and source principles and, unless sufficient
relief is provided, can lead to unrelieved double or even triple taxation.23 In this part, the domestic law
treatment of income from immovable property, capital gain and business profit, which are the main subjects in this paper, will be described.
3.1.1.2.1. Income from immovable property24
Domestic laws with respect to the characterization and computation of income from immovable property vary enormously. Although a review of countries’ practices in this regard is beyond the scope of this article, some generalizations can be made:
(1) First, income from immovable property located in a country is almost always treated as domestic-source income.
(2) Second, many countries, even civil law countries that as a general rule treat all income earned by resident corporations as business profits, categorize income from immovable property earned by non-residents as business profits or passive investment income. Several countries make this distinction on the basis of the existence of a PE. Income from
immovable property that is attributable to a PE is treated as business profits. (3) Third, income from immovable property that is categorized as investment income is
generally taxed on a gross withholding basis, although some countries – Canada, Germany, the Netherlands, the United Kingdom and the United States – provide for taxation on a net basis, sometimes by way of an election.
(4) Fourth, some countries have enacted rules allowing them to tax income and gains from the disposition of immovable property (which arguably do not constitute income from immovable property under Art. 6) as business profits even in the absence of a PE.
3.1.1.2.2. Capital gain
A comparison of the tax laws of the OECD member countries shows that the taxation of capital gains varies considerably from country to country:25
(1) in some countries capital gains are not deemed to be taxable income;
(2) in other countries capital gains accrued to an enterprise are taxed, but capital gains made by an individual outside the course of his trade or business are not taxed;
(3) even where capital gains made by an individual outside the course of his trade or business are taxed, such taxation often applies only in specified cases, e.g. profits from the sale of
immovable property or speculative gains (where an asset was bought to be resold).
Moreover, the taxes on capital gains vary from country to country. In some OECD member countries, capital gains are taxed as ordinary income and therefore added to the income from other sources. This applies especially to the capital gains made by the alienation of assets of an enterprise. In a
(Volume 70), No. 4, Section 3.1.2.3.
22 Fett, supra n.16, Section. 2.2. 23 Id.
24 This part is quoted from Arnold, supra n. 4, p. 9. 25 Para. 1 of OECD Commentary on Art. 13.
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number of OECD member countries, however, capital gains are subjected to special taxes, such as taxes on profits from the alienation of immovable property, or general capital gains taxes, or taxes on capital appreciation (increment taxes). Such taxes are levied on each capital gain or on the sum of the capital gains accrued during a year, mostly at special rates, which do not take into account the other income (or losses) of the taxpayer.26
3.1.1.2.3. Business Profits
The taxation of business income by source countries varies considerably. However, two general patterns can be noted. The most common pattern, consistent with Art. 7 of the OECD and UN Model Tax Convention, is that business income is generally taxable by a country only if the taxpayer carries on business through a PE in the country and the income is attributable to that PE. In these systems, the PE rules serve not only as a threshold for source country taxation but also as the means for identifying the income subject to tax, namely, income “attributable” to the PE. Most of European countries follow this general pattern: however, the definition of a PE under domestic law is often broader than the definition in tax treaties.
In many Latin American and South American countries, the PE concept is used to differentiate between the taxation of income from services derived by non-residents on a net or gross basis. residents who earn income from services derived by non-residents on a net or gross basis. Non-residents who earn income from services through a PE situated in a country are taxable by that country on a net basis (i.e., the non-residents are allowed to deduct expenses incurred in earning the income). Non-residents who earn income from services performed or consumed in the country but who do not have a PE in the country are taxable on a gross basis (without the allowance of any deductions) through a withholding tax.27
It does not deal with the issue of whether those expenses, once attributed, are deductible when computing the taxable income of the permanent establishment according to Art. 7(2)28 since the
conditions for the deductibility of expenses are a matter to be determined by domestic law, subject to the rules of Art. 24 on Non-discrimination (in particular, paras. 3 and 4 of Art. 24).29
3.1.1.3. Mismatches or conflicts in treaty application
The classification mismatch can lead to double taxation on the same income by each country. Tax treaties should solve this problem because one of the most important purpose of tax treaties is to eliminate International juridical double taxation.
Almost all tax treaties including the OECD and UN Model Tax Convention adopt the scheduler system having “other income” category and dividing incomes into active business income and passive income roughly. Generally, Arts. 6 to 21 of the OECD Model address the source state and either maintain or limit its taxation of income. Especially, when all other allocation rules are ruled out, the treaty provision modelled on Art. 21 of the OECD Model, which gives exclusive taxing rights to the residence stated in principle, will be relevant.
26 This part is quoted from Para. 2 of OECD Commentary on Art. 13.
27 These above two paragraphs is quoted from Arnold, Brian J., International Tax Primer (4th edition), Wolters
Kluwer, 2019, p.27.
28 Art. 7(2) provides that “For the purposes of this Article and Article [23 A] [23 B], the profits that are attributable
in each Contracting State to the permanent establishment referred to in paragraph 1 are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.”
3.1.1.4. Priority rule related to business profits under the Model Tax Convention
When it comes to business profits in Art. 7, there are some possibilities of overlaps with other income and it is solved by the priority rule. To be specific, Art. 7 governs business profits and provides that the source state may tax only when the resident of the other state carries on business through a PE within the meaning of Art. 5 in its jurisdiction and can tax only profits attributable to that PE. The implicit source rule in Art. 7, which adopts a threshold of PE in determining when the source state may tax the business profits of a non-resident, may also have an effect on taxation of income from immovable property if that income is considered as part of the business profits. For the purpose of applying a tax treaty identical to the OECD Model, Art. 7 is known as a lex generalis, and other distributive rules that take precedence over Art. 7 pursuant to Art. 7(4) are known as lex specialis.30
3.1.2. When is source state’s taxation not in accordance with the priority rule of tax treaties?
3.1.2.1. Different role of priority rule between under domestic law and tax treaty context
Priority rules under both domestic laws and tax treaties play a same role in deciding the priority between articles or between types of income in common. However, the role and legal effect of priority rules in domestic law may be more simple than in tax treaty context. Assuming the obvious overlap like the case without different identification of the facts in the light of different legal provisions
considered in domestic law context, taxable amounts or applicable tax rate can vary depending on the income qualification of each domestic law.
On the other hand, the overlap issue under international tax law contexts can be more complicated. In tax treaty and cross-border situations, at least two different tax law systems are usually applicable. Tax treaties cannot change this. They merely modify the legal consequences foreseen by national tax law by avoiding taxation in one of the two states in their scope of application or by obliging one of the two states to reduce the tax payable under its national law by the tax levied in the other state. As a result, tax treaties allocate taxation rights between the two states. Hence, priority rules under tax treaties mainly have the meaning where there is a mismatch of income classification between two different tax law sovereignties.
3.1.2.2. Should source always follow residence? 3.1.2.2.1. Issues
If so, is the priority rule necessary to identify one type of income between the overlapped whenever a mismatch takes place? Not actually. This is because almost all tax treaties including the OECD and UN Model Tax Convention have a mechanism to solve double taxation issues31 by the income
mismatch of each contracting state. According to Arts. 23A and 23B, residence follows source state’s different classification due to domestic law but also. To be specific, according to para. 32.1 et seq. of the OECD Commentary on Arts. 23A and 23B, the residence state, when applying Art. 23, does not have to categorize the income itself or check whether it (the residence state) would have been allowed to tax the income if it were the source state. All the residence state is required to do is to examine whether the source state has taxed the income in accordance with the treaty.32
Of course, if a qualification mismatch occurs due to different interpretation or understanding of facts, mutual agreement procedure according to Art. 25 should be carried on. However, what if the taxation of source state is definitely discordance with the tax treaty between two countries as unworthy of
30 Raad and Chen, supra n. 15, Sec. 2.5.3.1.
31 Double non-taxation should be solved by Art. 23A(4). Rust calls the case of resulting in double non-taxation as
“negative qualification conflicts”.(Rust, supra n. 17, p. 47.)
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consideration of MAP? It is obvious for the residence state not to give double tax relief in this case, but how does the tax authority of the residence state decide which case is not in accordance with in specific cases?
3.1.2.2.2. Domestic law in Japan and Korea (Rep.)
Before analysing the OECD Model, this article takes a short look at the domestic law of Japan and Korea to show the dilemma of some individual countries.33 Unlike Germany tries to solve this problem
by bilateral tax treaties,34 these two countries adopted some provisions in domestic tax law. Firstly,
Art. 162 and 163 of the Income Tax Act of Japan provides that:35
Article 162 (Domestic Source Income Subject to Tax Conventions) Notwithstanding the
preceding Article, if a convention that Japan has concluded for the avoidance of double taxation with respect to taxes on income contains provisions on domestic source income which differ from the provisions of the preceding Article, the domestic source income of a person subject to such a convention is governed by that convention, to the extent of the differing provisions. In such a case, if the convention contains provisions on domestic source income that replace the provisions of items (ii) through (xii) of that Article, income that the convention treats as domestic source income is deemed to correspond to domestic source income set forth in those items as regards the application of the parts of this Act that involve the particulars prescribed in those items.
Article 163 (Details of Scope of Domestic Source Income) Beyond what is prescribed in
the preceding two Articles, Cabinet Order provides for the necessary particulars concerning the scope of domestic source income.
Secondly, Art. 28 of International Taxation Adjustment Act of Korea (Rep.) provides:36
Article 28 (Preferential Application of Income Classification under Tax Treaty) The
provisions of the tax treaty shall preferentially apply to the classification of a domestic source income of a nonresident or foreign corporation, notwithstanding Article 119 of the Income Tax Act and Article 93 of the Corporate Tax Act.
However, such remedies can not give a clear-cut guideline for those countries to follow, either. The condition to change the income classification, income source, taxing right of the domestic tax law by tax treaty, the limitation, legal effect when the article is violated have been raised as lots of
interpretational issues.37 The argument in Japan and Korea moves to when the tax treaty can be
“directly applicable”. Indeed, the laws of Japan and Korea do not have the phrase “directly applicable”, but they borrows the wording of The Fiscal Code of Germany and the arguments from other
33 Art. 2(1) of The Fiscal Code of Germany can be compared to the cases of Japan and Korea (Rep.):
Section 2(Primacy of international agreements)
(1) Agreements on taxation concluded with other countries within the meaning of Article 59(2), first sentence of the Basic Law, shall take precedence over tax legislation insofar as they have become directly applicable domestic law
34 Rust, supra n. 17, pp. 47-48.
35 World Law Information Center operated by Ministry of Government Legislation of Korea website
(https://world.moleg.go.kr/web/wli/lgslInfoReadPage.do?CTS_SEQ=42429&AST_SEQ=2601&ETC=1, last
visited on 10 July 2020).
36 Korea Legislation Research Institute website
(https://elaw.klri.re.kr/kor_service/lawView.do?hseq=46375&lang=ENG, last visited on 10 July 2020).
37 See Namseok, Hwang, The Limitation of Change of Income Classification ― Regarding the Interpretation of
the Article 28 of International Taxation Adjustment Act ―, Tax Law Research, Tax Law Association(Korea), 2018.
countries38 to interpret the provisions above.39
3.1.2.2.3. Remedies deduced from the OECD approach
Normally, the OECD Model offers two steps to avoid double taxation.40 First, both states have to
classify the income and apply Arts. 6 to 21 of the OECD Model. Second, the residence state has to apply Art. 23 in order to relieve the remaining double taxation. The question is whether the residence state is obliged to carry out the second step and fall back on Art. 23 when, according to its view, the double taxation should not have arisen in the first place.41
In this regard, we need to go back to look at the allocation rules of the OECD Model. Four different types of provisions can be distinguished: (1) The source state is precluded from taxing the income. (2) The source state may tax the income up to a certain tax rate. (3) The source state has to restrict its tax base, i.e. it may not tax part of the income. (4) The source state may tax without limit, i.e. the taxation in the source state is maintained.42 Among them, the first type is called as “complete distributive
rules”43 while the other types are called as “open distributive rule”.
Generally, the application of a complete distributive rule means that there is no need to fall back on Art. 23.44 Double taxation and double non-taxation are avoided by applying the distributive rule which
excludes one of the contracting states from taxing the income. In cases of qualification conflicts, despite the application of a complete distributive rule by the residence state, double taxation and double non-taxation can arise because the source state’s interpretation differs from that of the residence state. If the application by the residence state of a complete distributive rule and Art. 23 is considered as mutually exclusive and consequently the solution for qualification conflicts, would be drastically reduced. In that case, the residence state could apply Art. 23 only when the income falls within the scope of an open distributive rule that allows the source state to tax the income fully or partly.45
3.1.2.3. The case of source states’ taxation not in accordance with the priority rule of tax treaties
This argument should also be applied to the priority rule of tax treaties. To be specific, in case that the allocation of taxing rights through the priority rule of a tax treaty leads to giving exclusive taxing rights, to one of the contracting states (residence state), the domestic law of the other contracting state (source state) cannot put back the outcome of allocation by the priority rule of tax treaties. The taxation of source state can be treated as a treaty override. The effect or remedy of tax treaty override
38 For example, Becker/Würm, ‘Double-taxation conventions and the conflict between international agreements
and subsequent domestic laws’, 16 Intertax 257 (198), p.258.
39 According to Namseok, Hwang,supra n. 37, p. 244, First, the provision of the tax treaty in question must be
applied directly or self-executing. When the provision of tax treaty is applied directly and competes with the domestic tax law on its requirements, the article is applied. However, in this case, the reservation principle should be considered. On the other hand, when the article is not applied to a case on which the article may be applied consciously or inconsciously the problem of hidden treaty override may occur. Though the remedies of the hidden treaty override may not be practical, it is important to recognize that such kind of override may occur. When the domestic tax law complements the contents of the tax treaty, the override also could occur if the newly revised domestic tax law goes beyond the context of the treaty. Also in that case the article may be violated in consequence.
40 Introduction (Para. 19) of the Commentaries to the OECD MTC. 41 Rust, supra n. 17, p. 45.
42 Alexander Rust, The New Approach to Qualification Conflicts has its Limits, BULLETIN - TAX TREATY
MONITOR, 2003, p. 46.
43 Reuven Avi-Yonah and Gianluca Mazzoni, Italy/European Union/OECD - Complete Distributive Rules and the
Single Tax Principle: A Review of Recent Italian Case Law, Ch. 4.
44 Rust, supra n. 17, p. 48. Rust quotes some German literature such as Frotscher, Internationales Steuerrecht,
at 111; Kluge, Das Internationale Steuerrecht(4th ed.,2000), marginal no. S.4; Schaumburg, Internationales Steuerrecht(2nd ed., 1998), marginal no. 16.205.
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can be very disputable depending on domestic legal systems,46 but it must be understandable for
residence state not to give double tax relief to taxpayers if source state apparently overrides the tax treaty between them.
In line with this argument, also regarding the case including immovable property and business profits, there are some noteworthy paragraphs of the OECD Commentary. First, the Commentary on Art. 6 of the OECD Model emphasizes that the priority rule, Art. 6(4) of the OECD Model does not prevent income from immovable property, when derived through a permanent establishment, from being treated as income of an enterprise, but secures that income from immovable property will be taxed in the State in which the property is situated. The para. 4 of the Commentary on Article 6 of the OECD Model provides:
3. Paragraph 3 indicates that the general rule applies irrespective of the form of exploitation of the immovable property. Paragraph 4 makes it clear that the provisions of paragraphs 1 and 3 apply also to income from immovable property of industrial, commercial and other enterprises. Income in the form of distributions from Real Estate Investment Trusts (REITs), however, raises particular issues which are discussed in paragraphs 67.1 to 67.7 of the Commentary on Article 10.
4. It should be noted in this connection that the right to tax of the State of source has priority over the right to tax of the other State and applies also where, in the case of an enterprise, income is only indirectly derived from immovable property. This does not prevent income from immovable property, when derived through a permanent establishment, from being treated as income of an enterprise, but secures that income from immovable property will be taxed in the State in which the property is situated also in the case where such property is not part of a permanent establishment situated in that State. It should further be noted that the provisions of the Article do not prejudge the application of domestic law as regards the manner in which income from immovable property is to be taxed. (underline added)
In addition, para. 4 of the OECD Commentary on Article 13, not mentioning Art. 7(4) explicitly, but describes the relationship between capital gain and business profit:
It is normal to give the right to tax capital gains on a property of a given kind to the State which under the Convention is entitled to tax both the property and the income derived therefrom. The right to tax a gain from the alienation of a business asset must be given to the same State without regard to the question whether such gain is a capital gain or a business profit.
Accordingly, no distinction between capital gains and commercial profits is made nor is it necessary to have special provisions as to whether the Article on capital gains or Article 7 on the taxation of business profits should apply. It is however left to the domestic law of the taxing State to decide whether a tax on capital gains or on ordinary iincome must be levied. The Convention does not prejudge this question. (underline added)
Although the paragraph expresses “It is left to the domestic law of the taxing State to decide whether a tax on capital gains or on ordinary income must be levied”, it assumes that the subject who decides the classification is one contracting state sharing the taxing right. That means that the income classification right of a contracting state is a matter after allocating taxing rights to the states. If a tax treaty gives exclusive taxing rights to residence state for some income by the complete distributive rules, it is meaningless for source state to argue whether the income is capital gain or business profit.
46 OECD Committee on Fiscal Affairs, “Report on Tax Treaty Overrides”, 1989, p. 3; De Pietro, Carla, Tax Treaty
3.1.3. Intermediate conclusion
Under scheduler taxation systems including active business income and passive income, the overlap of two types of income can take place. Also in tax treaty application context, an income qualification mismatch or conflict can happen in case that each jurisdiction classifies the same income differently. When the mismatch of conflict occurs, the OECD Model has a mechanism, which is the application of a complete distributive rule means that there is no need to fall back on double tax relief according to Arts. 23A and 23B. This principle should also be applied to priority rules under the OECD Model Tax Convention. In case that the allocation of taxing rights through the priority rule of a tax treaty leads to giving exclusive taxing rights, to one of the contracting states (residence state), the domestic law of the other contracting state (source state) cannot put back the outcome of allocation by the priority rule of tax treaties.
3.2. Analysis of the OECD position
3.2.1. PE triangular cases: The case is “Residence-Source-Source” Triangular Case
The PE triangular case could be a typical case of source states’ taxation not in accordance with the priority rule of tax treaties. Typical PE triangular cases occur where a person who is resident in one state (State R in the case) and which has a PE in a second state (State PE in the case), earns income from sources in a third state (State S in the case) which is attributable to the PE.47 It is so-called
Residence-Source-Source triangular case.48
Several types of PE triangular cases can be made.49 By far the most commonly discussed PE
triangular cases are those involving passive income.50 The case of overlapping active and passive
income is divided into two groups. The first is the overlap with dividends (Art. 10), interest (Art. 11) and royalties (Art. 12), and the second is the overlap with income from immovable property (Art. 6) or capital gains from immovable property [Art. 13(1)].
Where the first passive income group is involved, the applicable treaties would generally allow all three states (States R, S and PE) to impose tax the on the income and it is in these cases that the issues arising in PE triangular cases are most clearly evident. This is mainly because there are throwback rules in case of the income is effectively connected with a PE between Art. 7 and Arts. 10, 11 and 12 such as Arts 10(4), 11(4) and 12(3). To be specific, although the results of the application of the tax treaties may be different depending upon the types of the income and the relevant rules of the tax treaties, taxation of State S in general is restricted to a certain extent by provisions of the State R-State S tax treaty, while R-State PE would be allowed to tax the income attributable to the PE pursuant to the State R-State PE tax treaty. Since State S and State PE may both levy tax in accordance with the State R-State S tax treaty and the State R-State PE tax treaty, respectively, State R is obliged to grant relief according to article 23 of the State R-State S tax treaty and of the State R-State PE tax treaty.51
47 Fett, Emily, supra n.16, footnote 2.
48 Precisely, the case of immovable property situated in not a third state but a residence state (State R). does not
fall within the scope of the concept of PE triangular cases. Nevertheless, the logical principle to solve the problem may be similar.
49 Fett, supra n.16, Ch. 2.1. structures “Residence-Source-Source” Triangular Case as business profits (article
7), dividends (article 10), interest (article 11), royalties (article 12), income from immovable property (article 6), income from shipping, inland waterways transport and air transport (article 8), capital gains (article 13) and other income (article 21). It does not discuss income from employment (article 15), directors’ fees (article 16), artistes and sportsmen (article 17, although article 17 is discussed briefly in relation to business income), pensions (article 18), government service (article 19) or students (article 20).
50 Fett, supra n.16, Ch. 2.4. Fett classifies only dividends, interest and royalties into passive income, but more
commonly income from immovable property and capital gain might be categorized as passive income.
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In sharp contrast to the detailed set of rules dealing with the relationship between Art. 7 and the articles dealing with dividends, interest, royalties and other income, the relationship between Arts. 6 and 7 is that Art. 6 takes precedence in all situation.52 Thus, the outcome is substantially different
under the PE triangular case with the second passive income group because the OECD perspective gives exclusive taxing rights to Residence State in case of immovable property not situated in PE State as described above. To be specific, the OECD Commentary provides exclusive taxing rights should be given to State R according to Art. 21(1) for income from immovable property and Art 13(5) for capital gains. However, there is a heated disputable issue regarding Art. 6.
3.2.2. Income from immovable property in the case
3.2.2.1. Is Active business income not covered by Art. 6?
Papotti and Saccardo have argued that Art. 6(4) of the OECD and UN Models means that income from immovable property derived by an enterprise carried on by a resident of a state is never subject to Art. 7.53 This interpretation, however, may be easily challenged by a literal reading of Art. 6(4), as
Art. 6(4) does not exclude the application of Art. 7.54
3.2.2.2. Literal meaning vs. Context
Kees van Raad disagrees with the position of the OECD Commentary in the case because it is not in accordance with the provisions of the OECD Model.55 To be specific, when discussing immovable
property situated in State S in the case, Art. 6 is not applicable in the case because it applies only to income derived by a resident of a contracting state(State R) from immovable property situated in the other contracting state(State PE). This means that there are still some rooms that Art. 7 can still apply to income from immovable property depending on domestic law.56
On the other hand, Bosman refutes that the ‘context’ within the meaning of Art. 3(2) of the R-PE tax treaty – including Art. 21(2) of the treaty – prevents State PE from categorizing the income under Art. 7 of the treaty, regardless of its domestic law classification of the income as business profits.57
In the author’s view, Bosman’s argument seems to use the context beyond the literal meaning of treaty. In the case, if we follow Raad’s opinion, double source taxation can take place in the case of immovable property situated in State S (third country). In other words, since State PE is permitted to tax on a source basis, both States PE and S can tax the same income. In this case, Art. 23 of the State R-State PE tax treaty and Art. 23 of the State R-State S tax treaty would oblige State R to grant DTR for the tax imposed by State PE and State S.58 If there is a reasonable remedy to solve the
problem, it is inappropriate to interpret tax treaties beyond the literal meaning. 3.2.3. Capital gain in the case
It does not seem to be any discussion about priority between business profits and capital gain. Like the OECD perspective, Some authors solve triangular cases assuming capital gain of Art. 13(1) takes
52 Arnold, Brian, “At Sixes and Sevens: The Relationship between the Taxation of Business Profits and Income
from Immovable Property under Tax Treaties”, BULLETIN – TAX TREATY MONITOR, 2006, p. 6.
53 Papotti and N. Saccardo, Interaction of Articles 6, 7 and 21 of the 2000 OECD Model Convention, 56 Bull. Intl.
Taxn. 10, Journal Articles & Papers IBFD (2002), p.516.
54 Raad, Kees van and Chen, Shaomei, supra n.17, Ch. 4.2.1.2.2. 55 Id.
56 Id/
57 Bosman, supra n.15, p.48.
precedence over business profits of Art. 7.59 The author agrees with the OECD view, which interprets
Art. 13(5) should apply the case of capital gain. This is because we can not help admitting Art. 13 takes precedence over Art. 7 according to Art. 7(4). In other words, we can not but interpret the meaning of “items of income which are dealt with separately in other Articles” in Art. 7(4) under the OECD Model includes “capital gain” even though there can be some debatable issues the relationship between business profits and capital gain under the scheduler system conceptually.
3.2.4. Double tax relief in case State PE taxes the income or capital gain as business profits
In the author’s opinion, in case that State PE taxes the income from immovable property classifying it as business profits, State R shall give double tax relief for the tax levied by State PE unless the MAP is considered. This is because nobody can predicate State PE’s taxation is not in accordance with the tax treaty between States R and PE under the situation with heated debate on the allocation of taxing rights between two countries even though the OECD position is clear. The Commentary is an
important aid in interpreting the OECD Model, but there can be a reasonable disagreement with the Commentary, and the Commentary can not override the provisions of the OECD Model.60 On the other
hand, in case that State PE taxes the capital gain classifying it as business profits, State R should not give taxing rights. This is due to the fact that State PE’s taxation is not in accordance with Arts. 7(4) and 13(5), so there is no need to move back on Art. 23.
4. Possible Solutions
It is inappropriate for the outcomes vary depending on whether the remuneration is income from immovable property or capital gain from the viewpoint of principle of symmetry.61 Otherwise, even
though double tax relief should also be granted in the case of income from immovable property like capital gain case, the author believes that it is necessary the OECD Model and the Commentary in this issue should be revised to give more clarification pursuing the OECD position from a technical viewpoint. In this regard, in this Chapter 4, the author tries to provide some technical remedies after agonizing some policy considerations.
4.1. Policy considerations
4.1.1. Situs Principle
As mentioned in Ch. 3.2.1., in case of PE triangular case with dividends, interest and royalties, the applicable treaties would generally allow all three states (States R, S and PE) to impose tax the on the income. The reason that different treatments of PE triangular cases take place between Art. 7 and the articles dealing with dividends, interest, royalties is that there is the situs principle of immovable property. As mentioned in section 3.1., the situs principle means that the situs state has priority in taxing the income from immovable property and the immovable property itself.
4.1.1.1. The Situs Principle in International Tax Law
Other than Arts. 6, 13(1) and 13(5) of the OECD Model, there are several provisions adopting the situs principle of immovable property inside and outside of the OECD Model. Inside the OECD Model, according to Art. 22(4) of the OECD Model, the immovable capital is taxable only in the situs state since the residence state coincide. PE state is not allowed to tax the capital at all.62
Outside of the OECD Model Tax Convention, the OECD Model Double Taxation Convention on
59 Raad, Kees van and Chen, Shaomei, supra n.16, Ch. 4.2.1.2.2. and Fett, supra n. 2, Ch. 2.8.1. 60 Rust, supra note 17, p. 15.
61 See supra note 18. 62 Rust, Situs, p. 16.
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Estates, Inheritances and Gifts also recognizes the close link between immovable property and the country in which it is located. In the case mentioned in Para. 4 of the Commentary on Art. 21, if the entrepreneur dies, according to Art. 7 of the OECD Model on Estates, Inheritances and Gifts,63 only
the situs state may tax the immovable property.64 As immovable property does not fall within the ambit
of Art. 6 of the OECD Model on Estates, Inheritances and Gifts,65 the property is not taxable in the PE
state.66 In addition, although it is regarding consumption tax, VAT, the place of supply of immovable
property is where the goods are located at the time when the supply takes place pursuant to Art. 3167
of EU VAT Directive, and that of services connected with immovable property is where the immovable property is located according to Art. 4768 of EU VAT Directive.
4.1.1.2. Justification and criticism for the situs principle
The historical justification for sourcing income from immovable property where the property was located rested on the notion that the country itself ultimately protected property located within its territory.69 Consequently, this connection between country protection and the derivation of income
almost perfectly embodied the benefit principle and, therefore, source jurisdiction, in this respect, remains largely unchallenged. However, the principle can be criticized that whatever the original rationale for the unrestricted taxation of income from immovable property by the country in which the property is situated, this principle cannot be justified today, especially with respect to income from immovable property that is part of a business. Land is not special in this regard; it is simply another asset used in a business.70
4.1.2. Two possible propositions from a policy perspective
As mentioned several times before, the OECD position regarding the PE triangular case with immovable property is to share the taxing right between residence state and source state (the state immovable property is situated in), and not to give the PE state the rights to tax. There can be two possible propositions to change this outcome from a policy perspective:71
(1) If Arts. 6 and 7 apply to the same income, Art. 7 should take precedence, and
63 Art. 7 of the OECD Model on Estates, Inheritances and Gifts provides: “Property, wherever situated, which
forms part of the estate of, or of a gift made by, a person domiciled in a Contracting State, and not dealt with in Articles 5 and 6, shall be taxable only in that State.”
64 Para. 9 of the Commentary on Art. 7 of the OECD Model on Estates, Inheritances and Gifts.
65 Art. 6(1) of the OECD Model on Estates, Inheritances and Gifts provides: “Movable property of an enterprise
which forms part of the estate of, or of a gift made by, a person domiciled in a Contracting State, which is the business property of a permanent establishment situated in the other Contracting State, may be taxed in that other State.”
66 Wassermeyer, in Debatin/Wassermeyer, ErbStDBA, Art. 5 ErbStMA, marginal note 1 (March 1999). 67 Art. 31 of EU VAT Directive provides: “Where goods are not dispatched or transported, the place of supply
shall be deemed to be the place where the goods are located at the time when the supply takes place.” And Art. 14(1) of the Directive provides: “‘Supply of goods’ shall mean the transfer of the right to dispose of tangible property as owner.”
68 Art. 47 of EU VAT Directive provides: “The place of supply of services connected with immovable property,
including the services of estate agents and experts, and services for the preparation and coordination of construction work, such as the services of architects and of firms providing on-site supervision, shall be the place where the property is located.”
69 G.W.J. Bruins et al., Report on Double Taxation, League of Nations Doc. E.F.S.73.F.19, 1923, p. 28. 70 Id.
71 These two solutions are among the six proposed by Brian Arnold. The other four propositions are (3) Art. 7
should apply to all business profits, (4) The rules in Art. 7 for the computation of the business profits
attributable to a PE should also apply to the computation of income from immovable property under Art. 6, (5) Art. 6 should be limited to income from immovable property other than business profits attributable to a PE, and (6) Art. 6 should provide taxpayers with an election to have income from immovable property taxed on a net basis in accordance with the rules in Art. 7. He analyses these options mainly from the perspective of tax treaty interpretation, and admits possible solutions are intended to highlight issues, not to make
(2) If income is derived from immovable property effectively connected to a PE, the income should be subject to Art. 7.
To make the argument simple, the author tries to focus on income from immovable property (Art. 6), but it will be also applied to the context of capital gain.
4.1.2.1. If Arts. 6 and 7 apply to the same income, Art. 7 should take precedence (first solution)
This solution could be accomplished by an amendment to Art. 7(4) stating that, where the business profits attributable to a PE include items of income dealt with in in Art. 6, the provisions of Art. 7 shall apply to such profits.72 The result of such an amendment would be that any income from immovable
property that constitutes business profits attributable to a PE would be subject to the rules in Art. 7.73
In this case, the result of PE triangular case is to share the taxing right between residence state and PE state, and not to give the source state (the state immovable property is situated in) the rights to tax. This is because Art. 7 should be applied to the case under the treaty between States R and S, and we assumed that there is no PE in State S, so State S is not allowed to tax the income. The State PE, sharing the taxing rights with State R, would have the right to tax such income, but it would be limited to taxing the net profits attributable to the PE computed in accordance with the rules in Art. 7, including the OECD Transfer Pricing Guidelines applied by analogy as set out in the OECD
Discussion Draft.74
4.1.2.2. If income is derived from immovable property effectively connected to a PE, the income should be subject to Art. 7. (second solution)
Another alternative would be to add a throwback rule to Art. 6 similar to the throwback rules in Arts. 10(4),11(4), 12(3) and 21(2). By virtue of these throwback or renvoi rules, if a non-resident carries on business in a country through a PE located there and the property producing the income is effectively connected to the PE, then the income is taxable in accordance with Art.7 (whether or not the income is considered to be business profits under domestic law).75 A throwback rule in Art. 6 would provide that,
if a non-resident carries on business in the country through a PE and the immovable property is a PE or is effectively connected to the PE, Art. 7 applies to any income from the immovable property.76 In
this case, the applicable treaties would generally allow all three states (States R, S and PE) to impose tax the on the income like the PE triangular cases with dividends, interest and royalties.
4.1.3. The author's assessment
Whether an immovable property or a PE is closer nexus to the income is an issue beyond the scope of this article. It can need help from other academic fields such as economics, statistics, etc. Thus, the author just tries to point out some obstacles to change the current system. First, in the author’s opinion regarding the first solution, the approach of excluding the taxing right of State S (where immovable property is situated) and giving it to State PE is difficult to be politically acceptable. Also, the approach can be more vulnerable to treaty avoidance. Secondly, the outcome of the second solution is not only beside the point of this article but also inappropriate.
4.1.3.1. Regarding the first solution
4.1.3.1.1. Political acceptability: Repulsion against the passive investment of foreign capital
Immovable property including land can be simply one of the asset used in a business in these days. 72 Arnold, supra n. 53, p. 15. 73 Id. 74 Id. 75 Arnold, supra n. 53, p. 16. 76 Id.
