considerations driving their development
Adv LLM thesis
submitted by
Patrícia Duarte da Conceição Machado
in fulfilment of the requirements of the
'Advanced Master of Laws in International Tax Law'
degree at the University of Amsterdam
supervised by
Prof. Dr. 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.
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“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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_________________________________
Patrícia Duarte da Conceição Machado
Table of Contents
Table of Contents ... III
List of Abbreviations ... IV
Executive Summary ... V
Main Findings ... VI
Introduction ... 1
Objective and Research Question ... 2
Scope and Methodology ... 3
Research Plan and Structure ... 3
Terminology ... 4
Developed countries, developing countries and emerging economies ... 4
Source and residence State ... 4
1. Meaning and interpretation of (technical) services in the global economy ... 5
2. Treatment of technical services in the Model Tax Conventions ... 9
2.1. The 2017 OECD Model Convention ... 11
2.1.1. The OECD Committee of Fiscal Affairs ... 12
2.2. The 2017 UN Model Convention ... 14
2.2.1. The work of the UN Committee of Experts ... 16
3. The different positions of developing and developed countries ... 18
3.1. India, as the pioneer country in respect of technical services ... 19
3.2. Brazil, as a developing economy and BRICS country ... 20
4. Effectiveness of the current approaches in the protection of developing
countries’ taxing rights ... 23
Conclusion ... 29
List of Abbreviations
BEPS Base Erosion and Profit Shifting
BRICS Brazil, Russia, India, China and South Africa
CEN Capital Export Neutrality
CIN Capital Import Neutrality
DTC Double Tax Convention
FDI Foreign Direct Investment
G20 Group of Twenty
IMF International Monetary Fund
MLI Multilateral Instrument
MNE Multinational Enterprise
OECD Organization for Economic Co-operation and Development
PE Permanent Establishment
Executive Summary
The present work will deal with situations were technical services are paid by an enterprise to a non-resident service provider, situations typically subject to withholding tax at the source State and will not address situations where the income derived by the non-resident is business income or income associated to a permanent establishment or fixed base. Thus, the focus is chiefly on cross-border technical services and the specific treaty and domestic law provisions which are used to govern them.
In this sense, assessing how the meaning and interpretation has (or should have) evolved over time and which were the policy considerations driving such changes is fundamental for the evaluation of the allocation of taxing rights between source and residence in terms of effectiveness.
The duality between source vs. residence; developing vs. developed; net capital importers vs. net capital exporters; will be explored but not emphasized. Developing countries now play a significant role in driving policy changes in respect of the taxation of technical services, which should not be seen as an initiative opposed to the interests of developed countries under the auspices of the globalized attempt to counter BEPS.
It becomes clear that source taxation of technical services should be acknowledge as a “new normal” as the result of a more than needed paradigm shift. The importance of protecting the taxing claims of developing countries, which usually occupy a more vulnerable position in terms of tax collection, administration and information, is to ensure no opportunity of BEPS is overlooked. For this reason, attending to this long-standing claim of developing countries will likely produce beneficial outcomes that will affect equally developed and developing countries.
The current rules, either unilateral or established under DTCs, are not effective in the protection of the taxing rights of developing States. As a matter of fact, they enable MNEs to conduct their businesses in a manner that promotes erosion of the tax base of source countries and shifts profits to States with lower tax burdens. Although there has already been some progress in addressing such lack of effectiveness, a genuine paradigm shift is still needed. To achieve this outcome, it is necessary to acknowledge the weaknesses and shortcomings of the current approaches and focus on a long-term solution that even though may take time to be achieved, should at least start to be discussed.
The allocation of source taxing rights in respect of technical services seems not only effective but also efficient. The current proposals already bring many positive aspects, e.g. gross basis taxation, no threshold, base erosion as a nexus; all elements which are aligned with the current overhaul of the international corporate tax system.
However, it is necessary to go even further. Conflicts of interpretation and significance should be avoided to prevent falling into exactly the same endless interpretative disputes that exist today. For this purpose, it is suggested that any provision dealing with technical services should refrain from including specifying terms (i.e. technical, managerial, consulting, etc.) and just impose a withholding obligation over services.
Potential conflicts with other treaty provisions dealing with services can be avoided through a carve-out and the relation between lex specialis and lex generalis. Moreover, issues related to the possibility or not of deducting fees for services under the source State’s domestic law can be equally dealt with under other treaty provisions (i.e. non-discrimination provisions).
Main Findings
Although developed countries continue to steer the global wheel in economic terms, it is no longer possible to ignore the issues that affect developing countries more directly, not because developing countries have suddenly risen to a prominent position in the international tax debate, but because the challenges which need to be addressed are so intrinsically connected that it is impossible to dissociate.
This means that addressing BEPS in an effective way will inevitably mean taking into consideration the problems that affect developing countries as well as their interest, in order to achieve solutions of comprehensive application.
At the same time, the struggles of developing countries will have to be taken into account when designing the course of action, because if the proposed solutions are in practice inapplicable for a certain group of countries - due to lack of technical resources, knowledge, administrative force and economic means -, they are likely to achieve unsatisfactory results and allow the current challenges to remain in place.
In this sense, it should be in the interest on developed countries to adopt tax solutions which benefit “both sides”1, specially allowing developing countries to include in their tax treaties provisions which were historically deemed as asymmetrical (e.g. higher withholding tax rates applicable to royalties, interests, dividends and technical services), since asymmetry is the starting point of the interplay between developed and developing countries.
Symmetry and neutrality can only be achieved once a level playing field is created, which implies, as noted above, that effective solutions shall be balanced and equitable, the result of combining different - sometimes opposed - interests to find a common denominator which allows for optimized outcomes.
This compromise may imply a slower start, on the one hand, but at least will allow all interested stakeholders to move forward. On the other hand, one-sided solutions although may be believed to enable more immediate progress will, in all likelihood, be bound to clash in the future.
In the present work, the concept of technical services is evaluated in light of the abovementioned aspects, in order to assess whether the current treatment under tax treaties responds to the best interest of the developing countries and, as a consequence, contributes to the best interest of all international tax stakeholders.
As it turns out, the tax policies chiefly driving the meaning and interpretation of technical services are based on an obsolete notion of what services are and what is the necessary nexus for allowing source taxation. This is in dire need of revaluation and the momentum is now ideal, considering the initiatives under the BEPS Project and in special the work being conducted in respect of the Digital Economy.
1 Developed and developing countries are put as different sides just due to their intrinsic differences, specially under an economic context. However, it is not meant to imply that those sides are opposed to each other in an antagonistic way, but solely as two different parties with the same end goal with regards to the creation of tax policies which may drive economic growth and prosperity.
Introduction
Under the context of the G20/OECD project on BEPS, the entire international corporate tax system has been put under scrutiny and stress. Although the OECD work has historically been viewed as a result of developed countries’ interests, the presence of developing countries in the debate is an ever-growing element. Moreover, “a sincere evaluation of the justice of the current international tax regime can only be undertaken if the interests of non-OECD countries are taken into account. The addition of a G20 label to the BEPS initiative has contributed very little in terms of promoting such an inclusion”2.
Due to the increase of the relevance of developing countries in the global economy3, their presence in the centre of political debate and the focus of the BEPS Project on profit shifting and tax competition, the recognition of the interests of both emerging and developing countries has become a key concern4. This is because profit shifting and tax competition affects those countries more harshly causing their already vulnerable economies to take an even heavier toll.
In the context of the global economy, it is no longer possible for developed countries to address all the international corporate tax system issues alone, since many of the international tax arrangements will inevitably stumble upon an emerging or developing economy. In this sense, and also thanks to the work of international organizations (e.g. the UN and the IMF), it has been recognized that tackling and addressing BEPS depends also on taking the problems of developing countries into account, securing their interests and finding solutions that look upon their different realities5.
The traditional dichotomy between capital export and capital import6 has, to some extent, lost importance. The problems of both developed and developing countries need to be recognized as having similar - if not equal – importance and any plan for solving them should behold all sides, at the risk of not achieving any valuable outcomes.
In this sense,
The existing system of allocating taxing rights is supported by the concept of neutrality. Economic efficiency or tax neutrality may be defined as the optimal allocation of production resources and the minimization of any distortion caused by the tax system. Capital export neutrality (CEN) and capital import neutrality (CIN) are based on the idea
2 L.E. Schoueri, Arm’s Length: Beyond the Guidelines of the OECD: “It is better to be roughly right than precisely wrong.” (John Maynard Keynes), 69 Bull. Intl. Taxn. 12 (2015), Journals IBFD; p.716.
3 Global economy is here understood as the current economic scenario which involves highly digitalized means of production, business models influenced by such digitalization and a very advanced stage of economic globalization, where international trade of goods and services has become fluid and physical boundaries have become an aspect of secondary importance.
4 International Monetary Fund. International Corporate Taxation - Corporate Taxation in the Global Economy, IMF Policy Paper (IMF 2019); p. 6 (executive summary).
5 In this sense, “addressing the distinct concerns of developing countries is critical, as is making full use of the differing comparative advantages and mandates of relevant international organizations” (International Monetary Fund. International Corporate Taxation - Corporate Taxation in the Global Economy, IMF Policy Paper (IMF 2019); p. 2 (of the Executive Summary).
6 Capital Export Neutrality (CEN) is understood as “the situation that exists where resident investors bear the same tax burden whether they invest at home or abroad” (Arnold, B., International Tax Primer, Wolters Kluwer. - Forth Edition (2019); p. 226) and Capital Import Neutrality (CIN) is understood as “the situation that exists where residents investing in a source country bear the same tax burden as other investors in that country” (Idem). Traditionally, and put in a simplistic way, developed countries are typically capital export countries, while developing countries more commonly figure as capital import countries.
that the economic decision making of business should not be influenced by tax considerations. In a situation where there is CIN funds originating from another country should compete on equal terms with local funds on the domestic market. Where there is CEN the investor should pay the same total tax (including both domestic and foreign tax) whether the investment income comes from domestic sources or from foreign countries7.
For emerging and developing economies, “securing the tax base on inward investment is key”8. Although the direct influence of tax treaties in securing FDI inflows is debatable, the overall importance of inflows of capital to developing countries is not. This means that, as traditionally net capital importers, the biggest tax issues derive from the difficulty in ensuring that foreign capital gets taxed appropriately, securing the adequate level of source taxation in their territories.
The reasons why such difficulties exist are varied. Limited administrative capacity, complexity obstacles and lack of transparency are some examples. Tackling all factors with a single blow is unrealistic, reason why possible solutions should be based on prioritization.
In this sense, the discussion regarding whether tax treaties affect or not the level of FDI will be dealt with not exhaustively, but only to illustrate how the proposed prioritization should be addressed9. In any case, the weight and role of developing countries in the international corporate tax debate should be recognized and properly valued, since the allocation of taxing rights regarding technical services has become a common issue rather than an isolated problem.
Objective and Research Question
The main objective of the present study is to evaluate the role of developing States in the evolution of the treaty concept of fees for technical services and its effectiveness in protecting their taxing claims. In order to reach the proposed objective, the research will follow a research plan, through which the most relevant aspects and overarching issues regarding the treatment of fees for technical services under DTCs and the relevance of developing countries in this debate will be addressed.
The chosen line of research is very broad, reason why the objective of the present study had to be narrowed down. The main goal is thus to evaluate how technical services have evolved over time, with special focus on their evolution under DTCs in terms of meaning and interpretation. While conducting this evaluation, a secondary but intrinsically related evaluation will be conducted, with respect to the role developing countries have played in the aforementioned evolution.
7 M. Lang, & J. P. Owens, The role of tax treaties in facilitating development and protecting the tax base. WU
International Taxation Research Paper Series, (2014-03); p. 7.
8 International Monetary Fund. International Corporate Taxation - Corporate Taxation in the Global Economy, IMF Policy Paper (IMF 2019); p. 1 (of the Executive Summary).
9 “There seems to be no consensus in the academic studies attempting to determine the impact of tax treaties on FDI flows into developing and emerging economies. All the studies acknowledge the difficulty in isolating the influence of treaties from other variables such as the economic and political environment. Surveys of business suggest that MNEs look at whether there is a treaty and examine its provisions when deciding where to locate. Other things being equal, MNEs will favor a country with a good treaty network. How important this is will depend on the economic structure in each country, the relationship between treaty and domestic law and the attitudes of the administration and the courts in the application of the treaty”. M. Lang, & J. P. Owens, The role of tax treaties in facilitating development and protecting the tax base. WU International Taxation Research Paper
The relevance of the theme is great but becomes especially important under the context of the BEPS Project and the Digital Economy. Since technical services are not (yet) part of the BEPS Action Plan but are a relevant element within the Digital Economy, discussions in this regard may contribute to further development of suitable tax alternatives for the taxation of technical services, with special consideration to the interests of developing countries.
Furthermore, in order to achieve the proposed objective, the following questions will be addresses by the present study:
i) How the concept of technical services has evolved over time and which are the policy reasons behind this evolution?
ii) What is the role of developing countries in the evolution of treaty concept of technical services? iii) Was this evolution effective for the protection of developing countries’ taxing rights?
Scope and Methodology
The scope of study will be limited to technical services paid by an enterprise to a foreign beneficiary not connected to a permanent establishment (PE) in the source State (i.e. situations typically subject to withholding tax at the source State according to its domestic legislation). In this sense, although being a significant topic of discussion in other studies regarding technical services, PE considerations will be made briefly and only to the extent they are relevant to the specific scope of the research.
Moreover, the scope is also limited to cross-border technical services provided to an enterprise in a developing country by a service provider who is a resident in a developed country. This limitation is important to evidence the objective of evaluating the role of developing countries in the evolution of the meaning and interpretation of technical services, which is contingent to the analysis of relations between developing and developed countries.
The research methodology will be based on comparability analysis between Model Tax Conventions (OECD and UN) and its respective Commentary, the review of relevant literature and the study of unilateral measures adopted by developing countries to ensure source taxing rights over payments made in respect of technical services provided to enterprises situated therein.
Research Plan and Structure
The present study will be divided in four chapters, each of which will deal with relevant concepts and considerations of the research.
The first chapter (“Meaning and interpretation of (technical) services in the global economy”) will establish a concept of technical services for the purposes of the present study and assess how its meaning has evolved over time. It will emphasize policy considerations behind the allocation of taxing rights as well as the new business models which arise from the global economy.
The second chapter (“Treatment of technical services in the Model Tax Conventions”) will deal specifically with the OECD and UN Model Tax Conventions, evidencing the differences between the two
in respect of technical services, as well as the work of the OECD Committee of Fiscal Affairs and the UN Committee of Experts in this respect.
The third chapter (“The different positions of developing and developed countries”) will deal with approaches adopted by developing and developed countries when dealing with technical services and alternative provisions included under DTCs. The chapter will also address the inherent asymmetry between developing and developed countries, highlighting the important of emerging economies and the special contribution of the BRICS countries to the debate, specifically of Brazil and India.
Finally, the final chapter (“Effectiveness of the current approaches in the protection of developing countries’ taxing rights”) will approach the crisis of the international corporate tax regime and BEPS as one of its outcomes, as well as elaborate on the reach of BEPS effects in the Digital Economy. The chapter will explain that conflicts of interpretation in respect of technical services will continue to lead to endless disputes and that imposing limitations to source taxing rights is no longer justifiable.
Terminology
There are terms and concepts which will be repeatedly referred to throughout the present study, thus an a priori meaning should be established for ease of interpretation.
Developed countries, developing countries and emerging economies
Throughout the present study, the expression “developed countries” will be used as a synonym for countries which have achieved a certain degree of economic development and which typically occupy the position of net capital exporters. By contrast, “developing countries” will refer to countries which are still in a more elementary stage of economic development and generally figure as net capital importers. “Emerging economies” will signify developing countries which are more integrated to the global economy and that may occupy positions of both net capital importers and net capital exporters. The BRICS countries are an example of emerging economies.
Source and residence State
The Model Tax Conventions make reference to expressions for the identification of each one of the contracting States (i.e. the residence State and the “other” State) which can add difficulty of interpretation. For purposes of simplification, the present study will make reference to “source State” as the State where the beneficiary of technical services is located. By the same token, “residence State” will refer to the State of residence of the service provider.
Since the research will focus on the relationship between developed and developing countries, the expression “source State” will generally refer to a developing country, whereas “residence State” will designate a developed country.
1. Meaning and interpretation of (technical)
10services in the global economy
As the globalization phenomenon has evolved, so has the understanding of what services are. In the current state of economic globalization, highly based on the digitalization of the means of production, the intuitive idea of services no longer has the ability of encompassing all possibilities of how services can manifest. As an example, contemporary concepts such as SaaS (i.e. Software as a Service), cloud services and remote services in general, are business models widely used for the rendering of services nowadays, but that may not be part of the average man idea of services yet.
As is customary, law follows the facts of life, not the other way around. This means that legal concepts are created or updated ex post facto, thus after business practices are created and implemented, providing them with the necessary legal framework. In respect of services, the pre-existing notion that oriented most of the work done for international tax purposes is no longer appropriate to provide the necessary legal framework for the current business practices.
For this reason, it is necessary to establish a new meaning and a new form of interpretation of services, in particular of technical services, since this is the concept most commonly found in the framework of DTCs. For the purposes of this study, the more intuitive idea in respect of service will not be sufficient, so the meaning and interpretation will be evaluated in light of their practical meaning within the framework of Model Conventions and, when appropriate, related Commentary.
The importance of establishing the abovementioned elements derives from the ever-growing importance that services have undertaken. In this sense,
Services are becoming more and more important in both developing and developed economies and are increasingly traded internationally. The growth in cross-border trade in services now exceeds the growth in the cross-border trade in goods. Traditionally, double tax treaties were designed to divide taxing rights arising from cross-border trade between countries and were based predominantly on a business model that was focused on goods that were produced in physical locations.11
The definition of services (and more specifically of technical services) is both broad and variable, being even possible to say that it is to some extent volatile. This is because any attempt of defining a concept of (technical) services will be based upon the economic reality existing at the time such attempt is made, which has, since the advent of the global economy, been changing rapidly.
What is now a common practice (e.g. downloading a software from any place in the world) was virtually unthinkable not three decades ago. As the means of accessing services have changed, largely because of the internet and globalization, so have the business models for rendering services, as well as the types of services rendered.
In the 1990’s most services were hired and rendered on a personal basis. In the field of technical services this meant that services providers would have people with some sort of technical knowledge or 10 The term “technical” is here and subsequently is placed in brackets as a means to substantiate the argument that specifying terms such “technical”, “managerial” and “consultancy” will likely bring no benefit in terms of clarification but cause even more interpretative disputes.
11 UN Website. Taxation of Services. Available at: https://www.un.org/esa/ffd/tax-committee/taxation-of-services.html (accessed 31 Jan 2020).
expertise which was needed by the service user, which, especially in the field of managerial, technical and consultancy services, meant the physical presence of such technicians in the premises of the service user.
Moving forward to the current scenario, from the elements described above it is possible to identify that only the existence of technical knowledge remains, since the physical presence of a person at the physical location of the service user is often not seen. There was a shift from the personal basis to now a digital basis, which can be evidenced by both the way services are now offered and provided, but also by the types of services that are required.
Moreover, and considering the aforementioned change of basis, the rendering of services has followed the stride of the global economy, also shifting from the traditional model based on local services to a new model, which is global, digitalized and not personified.
Finally, with regard to the definition of technical services, it became particularly hard to identify categories of services which in essence cannot be included within the general definition of services which require some sort of technical knowledge or expertise.
As will be discussed further, technical services are understood, within the framework of DTCs, as services of a “managerial, technical or consultancy nature”. Since none of these terms are defined within that framework, at the end of the day interpretation12 will rely on the definition such terms may have under the domestic law of each State13, for qualifying a service as being of a “managerial, technical or consultancy nature” or not.
This prima facie distinction raises concerns and has already given room to disputes. Under many DTCs, technical services are included within the definition of royalties and taxed under Article 12, provided that such services involve the transfer of know-how or of any knowledge, experience or skills. Contrario sensu, services that do not impart know-how or technical knowledge should not be given the same treatment as royalties. Moreover, many States provide different withholding tax rates under their domestic law for technical services and services in general.
12 Pursuant to Article 3, paragraph 2 (of both the OECD and UN Model Conventions), any terms not defined within the Convention shall be understood as having the meaning that it has under the law of the contracting States, for the purposes of the taxes dealt with by the Convention. Application of the “unless the context otherwise requires” (or “unless […] the competent authorities agree to a different meaning pursuant to the provisions of Article 25”, cf. OECD Model Convention) interpretation seems not to be the case. Since an in-depth analysis of possibilities regarding the interpretation of the terms is not the intended objective in the present study, no further reference will be made to sources of interpretation for this regard.
13 Under the UN Commentary to Article 12A, paragraph 62 states that the terms “managerial”, “technical” and “consultancy” should be understood under its ordinary meaning and that “the fundamental concept underlying the definition of fees for technical services is that the services must involve the application by the service provider of specialized knowledge, skill or expertise on behalf of a client or the transfer of knowledge, skill or expertise to the client, other than a transfer of information covered by the definition of “royalties” in Article 12,paragraph 3”. Furthermore, although admitting the possibility of overlap between the meaning of the abovementioned terms, under paragraph 68 considers that application of Article 3, paragraph 2, for the determination of the meaning of the terms would be inappropriate. However, in the case of undefined terms, that is precisely the mechanism which should be used for purposes of interpretation. To emphasize this line of reasoning, Professor Fernando de Man observes that “this detailed guidance in the proposed Commentaries is based upon the misconception that the mere silence of the Commentaries or an explicit remission to the domestic law of the contracting States would result in a significant importance of the latter for definitional issues related to the concept of technical services. In the author’s view, it is not the Commentary which defines the context eventually required for an autonomous and conventional approach to undefined terms, particularly in an area in which the domestic law of many countries has a lot to say” in A. Báez Moreno, The Taxation of Technical Services under the United Nations Model Double Taxation Convention: A Rushed – Yet Appropriate – Proposal for (Developing) Countries?, 7 World Tax J. (2015), Journal Articles & Papers IBFD; p. 24.
It is important to establish a meaning because the lack of consensus on the interpretation may lead to disputes and ultimately to double taxation. However, any attempt of establishing a painstaking distinction on the meaning will inescapably face problems of interpretation, especially since the meaning of technical services has been changing rapidly and becoming more extensive.
Perhaps the solution to this impasse would be to abandon completely any attempt of differentiating and just considering services in general, regardless of the technical nature14. Although this approach may also raise concerns, under the framework of DTCs it could not generate a deleterious impact after all. Current proposals for the taxation of technical services, namely the new Article 12A introduced in the UN Model Convention, make an explicit carve-out15 for types of services or payments which are already dealt with under other treaty provisions or not within the scope of the article due to policy considerations (i.e. (a) payments of salary, wages or other remuneration to an employee of the payer; (b) payments for teaching in an educational institution or teaching by an educational institution, and (c) payments by individuals for services for personal use).
In this sense, the use of either “technical services” or simply “services” under such a provision would not pose a potential risk of conflict between treaty provisions, reason why, at least at a treaty level, the distinction has only a secondary relevance. It has primary relevance, however, in the interplay between treaty and domestic law, from where most controversies arise. Professor Brian J. Arnold explains this interaction between provisions in the domestic law and the treaty,
[…] Most countries tax nonresidents on their domestic source income. Some countries tax nonresidents on all their domestic source income; other countries tax nonresidents on their domestic source business income only if a minimum threshold, such as a PE or a minimum period of physical presence, is met. Under provisions of the OECD and UN Model Treaties, a source country is generally entitled to tax the profits of a business carried on by a resident of the residence country only if the business is carried on through a PE located in the source country and only to the extent that the profits are attributable to the PE. As a result of these provisions of domestic law and tax treaties, taxpayers, especially multinational enterprises, can structure their business operations to erode the tax bases of source countries through payments for technical, management, and consulting services […]16.
As a way of ensuring protection of their domestic tax base, developing countries commonly include special rules for taxing non-residents on fees for management, technical, and consulting services, which usually consist on a withholding tax imposed on the gross amount of the payments made by residents to non-residents in respect of those services.
The definition of source, under those rules, is varied. Some base on the conventional notion of source as the place where services are performed; others consider source as the place where the services are used or consumed. Finally, some base on the notion of source in respect of origin of payment. 14 “In order to avoid endless interpretative disputes about the very meaning of the technical character of a service, the best policy and legal approach would be to entirely refrain from adding adjectives and base the new withholding obligation upon the mere concept of services” in A. Báez Moreno, The Taxation of Technical Services under the United Nations Model Double Taxation Convention: A Rushed – Yet Appropriate – Proposal for (Developing) Countries?, 7 World Tax J. (2015), Journal Articles & Papers IBFD; p. 26.
15 UN (2017). Model Double Taxation Convention between Developed and Developing Countries. Article 12A, para. 3.
Depending on the notion of source used by the different provisions of domestic law of these countries, those provisions will affect services whether performed in the source country or not.
“One difficulty with these rules is that the types of services to which the rules apply are often not defined precisely”17. Similarly, under DTCs the definition of technical services is equally problematic. Even in DTCs where contracting States have decided to include a specific provision to allow source taxation over payments for technical services on a gross basis, the notion of technical services is associated to managerial, technical or consultancy services, which is also not defined.
From the aspects highlighted above, it is clear that the meaning and the form of interpretation of (technical) services is of the utmost importance for ensuring the efficiency of tax systems. Lack of clarity in this regard will result in conflict between treaty and domestic law, between different legal systems and likely lead to undesirable outcomes such as double taxation or BEPS.
The treatment of technical services under the Model Conventions will be further explored on the next chapter. However, it is already possible to conclude that the current assumptions on which the definition of services for international tax purposes is based are no longer valid. In this sense, some new assumptions are proposed for resignifying the meaning and interpretation of services:
§ Services do not necessarily rely on a personal element (i.e. personal basis) anymore.
§ Services can be performed without any form of physical interaction between the service provider and the service user
§ Services have an inherent intangible nature, being the payment made by the service user to the service provider its most tangible aspect.
Services can, thus, be generally understood as “activities performed by one person or a machine for the benefit of another person non-gratuitously”18. Technical services, although being defined within the framework of Model Conventions as services of a managerial, technical or consultancy nature, should be understood as services which are based on some degree of specialized knowledge or expertise. However, as it will be discussed below, the narrow interpretation of (technical) services is likely to produce adverse effects, reason why it will not be the focus of the present study.
17 B. J. Arnold, International Tax Primer, Wolters Kluwer. - Forth Edition (2019); pp. 212-213.
18 M. Castelon, International Taxation of Income from Services under Double Taxation Conventions: Development,
2. Treatment of technical services in the Model Tax Conventions
Both the OECD and the UN issued updated versions of their Model Tax Conventions which reflect significantly the BEPS Project initiatives19, the OECD 2017 Update and the UN 2017 Update, respectively. While the OECD Model Convention has been and continues to be the model more vastly used, the UN Model attempts to provide developing countries a greater say while negotiating tax treaties. In this sense, “from the perspective of the standardization of DTCs, the OECD Model Convention has been a success. Nevertheless, this accomplishment was not extended to its acceptance by the countries that were barred from its drafting process”20. This is because the OECD Model Convention depends on a compromise between the two negotiating parties which can only be equitable when reciprocity exists. In the relations between developed and developing countries, there is no level playing field and reciprocity will always depend on prior adjustments to balance off their inherent asymmetry. The OECD Model Convention has been criticized for being residence-oriented when dealing with the allocation of taxing rights, which does not favour developing countries who usually play the role of source country. Moreover, following up the developments of the BEPS Project, value creation has become a key element for rethinking the allocation of taxing rights and the prevention of BEPS, reason why the revaluation of “source” has become a key theme in the international debate.
In this sense, Professor Brian J. Arnold observes that
In general and in comparison to the UN Model Treaty, the OECD Model Treaty favors exporting (residence) countries over capital-importing (source) countries. Often if eliminates or mitigates double taxation by requiring the source country to give up some or all of its taxing rights on certain categories of income earned by residents of the other treaty country. This aspect of the OECD Model Treaty is appropriate if the flow of trade and investment between the two countries is reasonably equal […]21.
Regarding technical services as an item of income under tax treaties, historically they have received the same treatment as royalties22, thus as passive income. Under the OECD Model Convention, the allocation of taxing rights over passive income, notably dividends, interest and royalties23, usually favours the residence country, allowing the source country a residual right to tax through a maximum withholding rate imposed usually on the gross amount of the payment at a flat rate.
The rationale behind this is the idea that passive income24 is more volatile than regular business income, being the residence country in a better condition to capture and tax that income than the source country,
19 Both Model Conventions were published in The OECD 2017 Update was published in December 2017. The UN 2017 Update was published later on, in October 2018.
20 F. Souza de Man, Taxation of Services in Treaties between Developed and Developing Countries – A Proposal for New Guidelines (IBFD 2017), Books IBFD.
21 B. J. Arnold, International Tax Primer, Wolters Kluwer. - Forth Edition (2019); p. 149.
22 Often technical services are dealt under tax treaties under Article 12, thus included in the definition of royalties for treaty purposes. This however is not verified in all DTCs, being equally common for treaties to only deal with technical services either under Article 7 or Article 5. In the case of developing countries, which occupy the position of net capital importers, the use of Article 12 is recurrent, reason why the above reference was made. 23 OECD (2017). Model Tax Convention on Income and on Capital, Articles 10, 11 and 12, respectively.
24 Passive income is understood as income derived from of assets, rather than income which is derived from the business of an enterprise. Under most DTCs, passive income is taxable in both States. Typically, the residence
here understood as the source in terms of payment. Under this rationale, value generation is assumed to occur outside the source country, at the hands of the beneficiary of the services, who perceived the economic results of the cross-border transaction.
Nonetheless, capital importing countries have a special interest in ensuring source taxation over passive income, given that this type of income tends to flow from developed to developing countries25, reason why developing countries are expected to require significant taxation at source of these items of income, through withholding taxes which are at least compatible with their domestic tax law26.
However, and how many countries – especially developing countries – have recognized in their DTCs, in the specific case of technical services this rationale, which derives from the treatment of royalties, is no longer ideal. In fact, the rendering of technical services is part of the business activity of the service provider and should not receive the same treatment as passive income under the DTCs.
In this sense, it has already been recognized that amongst the item of income subject to withholding tax under DTC, i.e. usually passive income, “the strongest case for higher withholding rates is for royalty income and income from technical services. Unlike debt capital which can be easily moved to countries that yield the highest after-tax rate of return, royalty payments are generally made for use of intangible property in a particular jurisdiction”27. Likewise, imposition of higher withholding taxes for non-passive income, as is the case of technical services, is also recognized as an alternative to be seek by developing countries attempting to increase source-based taxation.
Oddly enough, up until 2016 neither the OECD Model Convention nor the UN Model Convention contained any specific provisions regarding the taxation of services.
The application of a withholding tax for this type of non-passive income, as done under the UN 2017 Update, may be a viable solution for ensuring developing countries a fair share of tax revenue on this type of income. Furthermore, the new business models involving the rendering of technical services are diverse and often do not express clearly the duality source-residence, making it difficult for both sides to properly tax the income.
Before the introduction of the new Article 12A under the UN Model Convention, allocation of taxing rights in respect of technical services was very restrictive. Under both the models, there was no specific provision dedicated to technical services as an item of income. Hence, the rules of Article 7, together with Articles 5 and 14 would apply. This means that the State of residence of the enterprise would have the right to tax the income, being the source State left with a residual right in case of services rendered through a permanent establishment or fixed base.
Under several DTCs different solutions for allowing source States to have a larger share of taxing rights were introduced, which end up leading to inconsistencies and making their application difficult. One commonly observed mechanism is the inclusion of the term “technical services” (often accompanied by
country has unlimited taxing rights over passive income while, under certain circumstances, the source country may impose a withholding tax on the payment according to a maximum established under the DTC.
25 Lang, M., & Owens, J. P. (2014). The role of tax treaties in facilitating development and protecting the tax base. WU International Taxation Research Paper Series, (2014-03).
26 In this sense, whereas many developed countries choose to exempt foreign business income as a way of providing incentive and competitive conditions for their national MNEs, developing countries can strongly rely on withholding taxes imposed on outflows of income as a source of revenue.
27 E. M. Zolt, Taks treaties and developing countries, WP18/05 Working paper series, Oxford University Centre for Business Taxation (2018); p. 25.
the term “technical assistance”) via protocol, as reference to Article 12, thus including It in the concept of royalties for treaty purposes.
Although effective to guarantee source countries more opportunity to tax transactions involving cross-border services, approximating the concept of “technical services” to the concept of royalties gave rise to another debate, of whether such services did or did not involve the transfer of the use of, or the right to use, property or know-how. In the overall, this approximation ended up serving as a crutch rather than a final solution and lead to uncertainty which is undesirable for taxpayers and tax authorities alike. Royalties and technical services may be intrinsically connected, but more often than not the rendering of services to a customer does not involve any transfer of property or know-how. It may be fair to say that situations where such transfer occurs are exception and not the rule. Therefore, associating the meaning of technical services to the concept of royalties under Article 12 does not reflect reality and may result in forfeiture of taxing rights to the source State, whenever there is a situation in which the services dealt with cannot be interpreted as royalties so directly.
As a direct consequence of the BEPS Project, services carried out with no significant physical presence began to occupy the spotlight of the international debate. Not only because of the uncertainty on its treatment, but also for giving room for erosion of the taxable base through deductibility and to the possibility of profit shifting in intercompany transactions.
Those concerned are shared between developed and developing countries, but become especially serious for the latter, “because they are disproportionately importers of technical services and often lack the administrative capacity to control or limit such BEPS through anti-avoidance rules in their domestic law and tax treaties”28.
2.1. The 2017 OECD Model Convention
The OECD Model Convention has been the paragon of DTCs negotiated worldwide, between OECD members States, but also serving as basis for the negotiations between non-OECD countries. The OECD Model Convention is the most influential and generally used model but considered to favour the interests of developed countries (i.e. typically countries who seek CEN and occupy the position of residence State) due to its focus on granting taxing rights to residence States.
In this regard, under the OECD Model Convention the allocation of taxing rights arising from passive income (i.e. dividends, interest, royalties and capital gains) typically favours the residence country. In respect of services, profits arising from services performed by an enterprise in a given source State are not taxable at this State, unless such profits are attributable to a permanent establishment situated there or subject to a different provision under the Convention that allows so. As a result, the State of residence of the enterprise has exclusive right to tax the income, under Article 7 of the Convention.
Under the OECD Model Convention there is no specific provision dealing with income from technical services provided by a resident of one State in the other contracting State. Although there have been discussions within the OECD regarding the taxation of services and the possibility of inclusion of a specific provision to deal with those services, so far the understanding is that it would be inappropriate to include a standalone provision.
28 UN (2017). Model Double Taxation Convention between Developed and Developing Countries. Article 12A Commentary, para. 10.
2.1.1. The OECD Committee of Fiscal Affairs
The OECD Model Convention, its 2017 Update, as well as its Commentaries are the result of the work of the OECD Committee on Fiscal Affairs (hereinafter “the Committee”), whose mandate include contributing to the global economy “through the promotion and development of effective and sound tax policies, international tax standards and guidance that will allow governments to provide better services to their citizens while maximizing economic growth and achieving environmental and social objectives”29.
The work of the Committee seeks to enable OECD member States and non-members to improve the design and operation of national tax systems, promote co-operation and co-ordination in the area of taxation and reduce tax barriers to international trade and investment30.
Furthermore, in order to fulfil its objectives, the Committee shall “support the development of efficient and equitable tax systems, consistent with maximising the growth potential of OECD Members and Partners, […] through the analysis of tax policy issues, comparative statistics, comparisons of country experiences in the design of tax systems and by sponsoring or conducting research into tax design and related issues”31.
The Working Party No. 1 is the subcommittee of the Committee which is responsible for updating the OECD Model Convention. As mentioned above, the OECD Model Convention has never included and still has no specific provision dealing with the taxation of services. However, Working Party No. 1 set up a Working Group, in 2004, to analyse the treatment of services under the provisions of the OECD Model Convention32 and “in particular, to examine the policy considerations for the allocation of taxing rights between the State of residence and the State of source with respect to income from services”33. The Report issued by the Working Group concluded that no changes should be made to the OECD Model Convention and the model remains until today without any specific provision related to services. The rules applicable to services as analysed by the Working Group at the time are the same rules applicable today.
The Working Group understood that granting exclusive right to tax to the State of residence of the enterprise in consistent with the background policy of the Convention and also supported by administrative considerations. Moreover, they observe that “it is indeed consistent with the principle of Article 7 that until an enterprise of one State sets up a permanent establishment in another State, it should not be regarded as participating in the economic life of that State to such an extent that it comes within the taxing jurisdiction of that other State”34.
Acknowledgements were made in respect to alternative provisions perceived by States who wished to preserve source taxation rights. In this respect, the Working Group considered that in any case any alternatives negotiated under DTCs should respect the following principles:
29 OECD Website. On-Line Guide to OECD Intergovernmental Activity. Committee of Fiscal Affairs. Available at: https://oecdgroups.oecd.org/Bodies/ShowBodyView.aspx?BodyID=963&Lang=en (accessed 31 Jan 2020). 30 OECD Website. On-Line Guide to OECD Intergovernmental Activity. Committee of Fiscal Affairs. Available at:
https://oecdgroups.oecd.org/Bodies/ShowBodyView.aspx?BodyID=963&Lang=en (accessed 31 Jan 2020). 31 OECD Website. On-Line Guide to OECD Intergovernmental Activity. Committee of Fiscal Affairs. Available at:
https://oecdgroups.oecd.org/Bodies/ShowBodyView.aspx?BodyID=963&Lang=en (accessed 31 Jan 2020). 32 At the time, the OECD Model Convention was on its fifth version (2003).
33 OECD. The Tax Treaty Treatment of Services: Proposed Commentary Changes. Public Discussion Draft, Center for Tax Policy and Administration (OECD 2006); p.2.
34 OECD. The Tax Treaty Treatment of Services: Proposed Commentary Changes. Public Discussion Draft, Center for Tax Policy and Administration (OECD 2006); p.2.
i) Source taxation should not extend to services performed outside the territory of a State; ii) Source taxation should apply to the profits rather than to the payments, and
iii) Source taxation should only be allowed if there is a minimum level of presence in a State. The conclusion of the Working Group recognizes physical presence as the solely possible nexus for allowing source taxing rights in respect of services, thus rejecting any possibility of the source State having taxing rights over services performed outside its territory (with no mention made to services performed by related parties). Moreover, in the presence of such nexus, only the profits derived should be taxed, as opposed to the gross payments.
Finally, reinforcing the notion explained in the previous paragraph, the Working Group considers that even when services are provided within the source State, source taxing rights may be denied due to compliance and administrative reasons, e.g. services provided during a very short period of time.
The Report not only covered the conclusions above, but also proposed changes to the OECD Commentary on Article 5. The paragraphs added in 2008, following up the Report, remain in the current version of the OECD Commentary (paras. 132-169, previously paras. 42.11-42.48). It is important to note that paragraph 42.16 (para. 137 of the 2017 version) recognizes the concern regarding business that do not require physical presence in the territory of the source State in order to carry on a substantial level of business activities there.
The rebuttal to those concerns is brought forward under paragraph 42.18 (para. 139 of the 2017 version), reproduced below, which States that the mere import of services should not give rise to source taxing rights, as an analogy to the treatment of the mere import of goods.
Under tax conventions, the profits from the sale of goods that are merely imported by a resident of a country and that are neither produced nor distributed through a permanent establishment in that country are not taxable therein and the same principle should apply in the case of services. The mere fact that the payer of the consideration for services is a resident of a State does not constitute a sufficient nexus to warrant allocation of income taxing rights to that State (emphasis added).
Hence, the work which resulted in the 2006 Report is still the only extensive work conducted by the Committee in respect of services. Although the paragraphs added to the Commentary foresee an alternative provision35, the conclusions of the Committee reflected in the current versions of the OECD Model Convention and Commentary still rely on the principle of exclusive residence taxation or services and on physical presence as the only possible nexus to allow taxation.
35 The 2006 Report added an alternative services PE provision (para. 144 of the 2017 version, previously para. 42.23) as an example of provision which could be added to treaties. The alternative provision would supposedly extend the PE definition already existing within the OECD Model Convention, to encompass income from services provided by non-residents. However, such provision would be dependable on physical presence as a nexus, thus “should not extend to services performed outside the territory of a State” (OECD (2017). Model Tax Convention on Income and on Capital. Article 5 Commentary, para. 143). Moreover, the provision would only be applicable to profits derived from services, not to the payments.
2.2. The 2017 UN Model Convention
The UN Model Convention is largely inspired on the OECD Model Convention but attempts to achieve a better balance in the allocation of taxing rights in the DTCs negotiated between developed and developing countries. In doing so, the UN Model Convention altered a series of articles with the objective of ensuring more taxing rights to the source States.
In general terms, the UN Model Convention brings out a broader definition of permanent establishment and attributes profits to that establishment more easily, giving rise to more situations where the source country gains taxing rights on active income. It gives special focus to the articles related to passive income (i.e. Articles 10, 11, 12 and 13).
While the OECD Model Convention gives residence States the primary right to tax passive income, the UN Model Convention establishes a general policy of shared taxing rights, brings a broader definition of royalties and introduces, under its 2017 Update, the new Article 12A as a standalone provision specifically aimed at fees for technical services, which is partly reproduced below:
Article 12A
FEES FOR TECHNICAL SERVICES
1. Fees for technical services arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.
2. However, notwithstanding the provisions of Article 14 and subject to the provisions of Articles 8, 16 and 17, fees for technical services arising in a Contracting State may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner of the fees is a resident of the other Contracting State, the tax so charged shall not exceed ___ percent of the gross amount of the fees [the percentage to be established through bilateral negotiations].
3. The term “fees for technical services” as used in this Article means any payment in consideration for any service of a managerial, technical or consultancy nature, unless the payment is made: (a) to an employee of the person making the payment;
(b) for teaching in an educational institution or for teaching by an educational institution; or (c) by an individual for services for the personal use of an individual.
[…] 5. For the purposes of this Article, subject to paragraph 6, fees for technical services shall be deemed to arise in a Contracting State if the payer is a resident of that State or if the person paying the fees, whether that person is a resident of a Contracting State or not, has in a Contracting State a permanent establishment or a fixed base in connection with which the obligation to pay the fees was incurred, and such fees are borne by the permanent establishment or fixed base. […]
Although the Commentaries to the UN Model Convention are largely inspired by the OECD Commentaries, the Commentaries to Article 12A have no correspondence in the other model, for the obvious reason that there is no standalone provision dealing with fees for technical services therein. The OECD Commentaries are silent in relation to technical services, making incidental references for the distinction from the concept of know-how.
Under the UN Commentaries to Article 12A, fees for technical services are defined as “payments for services of a managerial, technical or consultancy nature”36. Henceforth, any mention to “technical services” in the present work is meant to include all service items mentioned above.
The UN recognized the need for a new approach regarding the allocation of taxing rights arising from technical services, since in face of the new business models of cross-border service rendering exclusive residence taxation37 has become insufficient as a means to prevent double taxation, double non-taxation and tax evasion or avoidance.
The rendering of cross-border services without any presence in the source country has become an ever more common practice. There is great possibility for an enterprise to be present in another State’s economy without any substantial physical presence, i.e. economic presence is no longer connected to physical presence, which was the orienting notion behind the previous models.
The UN points out the recommendations under Final Report on Action 1 of the BEPS Project38 as one possible justification for the implementation of Article 12A, having recognized that although the Report does not recommend a withholding tax on digital transactions or recognized economic presence as a nexus for taxation, it recognized that countries can include such provisions in their DTCs as a general safeguard against BEPS.
Moreover, the new article focused on taxing technical services that may not be connected to any physical presence, in line with the BEPS Project concern to address the challenges of the Digital Economy. The notion that the source country should have the right to tax only in the case of services rendered within their territory is outdated and considerations regarding the nexus should focus more on the economic connection and place of consumption.
As an alternative for the inclusion of the new Article 12A, the UN Commentary suggest a narrower approach39, according to the solutions already in place in some DTCs, where fees for technical services are included under the scope of Article 12, but must be directly connected to property producing royalties, i.e. fees for services directly related to the enjoyment of property which gives rise to royalty payments as defined under the article.
Lastly, a perhaps even broader alternative would be to exclude the term “fees for technical services” and apply Article 12A to all fees for services provided in a State or outside the State by a closely related person, except for the payments expressly excluded under para. 3. This alternative would eliminate uncertainties regarding the definition of technical services and although not allowing the source country to tax services paid to non-closely related service provider for services provided outside the source country, would encompass the situations which are at higher risk of allowing for the erosion of the taxable base, which is payments for services provided outside the source State by a closely related party (i.e. precisely the situation of services provided between related enterprises).
36 UN (2017). Model Double Taxation Convention between Developed and Developing Countries. Article 12A Commentary, para. 1.
37 Under the OECD Model Convention, income from services is taxable exclusively by the State of residence of the enterprise, unless this enterprise carries on business in the source State through a permanent establishment.
38 BEPS Action 1: “Addressing the Tax Challenges of the Digital Economy”.
39 Paras. 24-25 of the Article 12A Commentary, when referring to the alternative approach, reckon that defenders of this narrower scope were the minority amongst the members of the Committee of Experts on International Cooperation in Tax Matters, remaining the broad approach (i.e. inclusion of the full new provision) the official recommendation.
The article proposes the application of a withholding rate over the gross basis of the payment in respect of the services. This approach is justified on the grounds of simplification as well as reliability, since it allows for tax imposition without requiring significant administrative capacity, from the tax authorities’ standpoint, but also allows for service provision without requiring excessive compliance measures from the non-resident enterprise.
Likewise, the provision is not based on any threshold (e.g. permanent establishment, fixed base, minimum period), which is justified by the fact that the current business models for provision and delivery of services are scarcely based on physical presence, but at the same time brings out a big concern regarding the possibility of BEPS.
The article is lex specialis in respect of the provisions contained in Article 7, pursuant to paragraph 6 of the latter provision. The same applies for the provisions of Article 14. Finally, there is no overlap between the new article and the provisions set forth under Articles 15, 18 and 19, which are expressly excluded. In terms of territorial scope, the provision applies only in the bilateral relations between the two contracting States, not reaching third States.
2.2.1. The work of the UN Committee of Experts
The UN Committee of Experts on International Cooperation in Tax Matters (hereinafter “the Committee of Experts”) is composed by twenty-five members appointed by the Secretary-General and has several subcommittees, with a mandate that includes tax treaties between developed and developing countries as well as bearing on international cooperation in tax matters40.
One of the subcommittees of the Committee of Experts is especially dedicated to the reviewing and update of the UN Model Convention, i.e. the Subcommittee on the UN Model Tax Convention between Developed and Developing Countries, whose mandate is to consider, make recommendations and propose drafts for the updates to the UN Model Convention.
The publication of the 2017 Update to the UN Model Convention with the inclusion of the new Article 12A was a result of the work of the subcommittee, also based on the studies conducted by the Subcommittee on the Taxation of Services41, whose work dates back to 2009 and has counted with the assistance of Professor Brian J. Arnold.
The main policy consideration which drove the work of the Subcommittees were the following42:
§ The risk of base erosion is a self-supporting justification to allow the source State (i.e. the payer’s State) to tax services, no additional justification being needed.
§ Intragroup services are a commonly used mechanism for BEPS. Granting the source State, the right to tax those services is a way of curbing such practices.
40 UN Website. Committee of Experts on International Cooperation in Tax Matters. Available at https://www.un.org/esa/ffd/tax-committee/about-committee-tax-experts.html (accessed 31 Jan 2020).
41 “At the 2008 Annual Session, the Committee of Experts on International Cooperation in Tax Matters set up a new subcommittee which was mandated to work on proposals for updating and improving Article 14 of the UN Model and the tax treatment of services”. UN (2009). Note Provided by the Coordinator of the Subcommittee on Article 14 and the Tax Treatment of Services. Available at https://www.un.org/esa/ffd//tax-committee/taxation-of-services.html (accessed 31 Jan 2020).
42 M. Castelon, International Taxation of Income from Services under Double Taxation Conventions: Development, Practice and Policy. Series on International Taxation, no. 63 (2018), Wolters Kluwer.
