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Abbreviations
- Michael Kobetsky
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2 - International taxation: policy and law
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Summary
Introduction
The national income tax systems of developed countries and principles of tax jurisdiction were shaped in the early years of the twentieth century when their economies were relatively independent and closed. Before World War I income taxes were not used extensively in developed countries and most enterprises restricted operations to their domestic markets, with international trade and investment being limited and heavily regulated. Nevertheless, cross-border investment and commerce were growing, and, in response, countries entered into bilateral tax treaties (tax treaties) with other countries to overcome the double taxation arising from international trade and investment. The network of tax treaties expanded significantly following the development of a model tax treaty by the League of Nations in the 1920s, based on the principles, policies and concepts of the inter-war period. International taxation comprises national tax systems and a network of tax treaties.
While enterprises have globalized, and operate as integrated international businesses, tax authorities typically operate independently with some international cooperation measures, such as information exchange. Many international enterprises have acted deliberately to limit information they provide to tax authorities in the jurisdictions in which they operate, which may prevent tax authorities from having full knowledge about the operations of enterprises. Even though tax treaties contain exchange of information measures, these measures are still underused by tax authorities. Developments in international taxation have not reflected the significant changes in the international trade system that have occurred since the end of World War II. Globalization has created an integrated international economy, and the implications of this change are profound. International enterprises may engage in worldwide tax planning, but at times, the tax planning may amount to tax avoidance. This situation reflects the significant imbalance of power between international enterprises and national tax authorities.
4 - History of tax treaties and the permanent establishment concept
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Summary
Introduction
The current international tax treaty system still reflects the principles and structures developed in the 1920s by the League of Nations, despite the effects of globalization. These principles were developed in a world economy in which international trade was in tangible items and international communication was slow. During the inter-war period, the double taxation of cross-border income resulting from the overlap of source jurisdiction and residence jurisdiction led to calls for measures to prevent double taxation. The International Chamber of Commerce (ICC), on behalf of enterprises, articulated a pressing need for measures to prevent double taxation. In 1928, the League of Nations developed its first model tax treaty to prevent double taxation, and this was the foundation of the 2010 OECD Model, the UN Model and of modern tax treaties. The League of Nations could not foresee the longevity of the principles and structure of its 1928 model tax convention, nor that the bilateral tax treaty system would become an extensive network. Its preference was for a multilateral tax treaty system with multiple bilateral tax treaties being a compromise intermediate measure.
This chapter surveys the history of the work of the League of Nations on international taxation and its dual focus of preventing double taxation and countering tax evasion. Despite the significant changes in international trade and commerce that have occurred since the 1920s, the main international tax issue is still the same – resolving the competing claims of a source country and a residence country to prevent double taxation, tax avoidance and tax evasion. The source country, where income is earned, and the residence country, where an international enterprise is based, both claim taxing rights over cross-border income. The principal aim of tax treaties is to resolve the competing and overlapping taxing rights of a source country and a residence country to prevent double taxation. But the allocation of source country and residence country taxing rights results in winners and losers. Usually developing countries prefer source country taxation as they are net importers of capital (capital-importing countries). On the other hand, developed countries prefer residence taxation as they are net exporters of capital (capital-exporting countries). The League of Nations attempted to strike a balance between these competing taxing rights. International enterprises and multinational enterprise groups, which are usually based in capital-exporting countries, and their national governments, have a common interest in preventing double taxation as it inhibits international trade and economic growth.
9 - Business restructuring involving permanent establishments and the OECD transfer pricing methods
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Summary
Introduction
The key features of international enterprises and multinational enterprise groups are that they carry on business operations in several countries and they conduct cross-border transactions; their size and centralized control provide them with efficiencies and cost savings from their intra-entity or intra-group transactions respectively, which are unavailable to independent enterprises carrying on similar business operations. Their reason for engaging in business restructuring is usually to either maintain or improve their competitive position; these enterprises engage in business restructuring to maximize synergies and economies of scale, to streamline the management of business lines and to improve the efficiency of global operations. Business restructuring is defined by the OECD as the cross-border transfer by an enterprise of functions, assets and risks.
A permanent establishment is treated as a separate and independent enterprise under the authorized OECD approach for attributing profits to the permanent establishment under the 2008 Commentary on former Article 7(2) and new Article 7(2). Permanent establishments may be involved in the business restructuring of an international enterprise if assets, functions and risks are transferred to, or from, a permanent establishment. The authorized OECD approach requires such transfers to be recognized for the purposes of Article 7. Business restructuring of international enterprises operating abroad through permanent establishments inevitably leads to changes in the allocation of business profits to the permanent establishments involved in the restructuring. Under former Article 7 the change in the allocation of profits must be consistent with the arm's length principle, but applying the arm's length principle to permanent establishments raises complex issues. Under the authorized OECD approach in the 2008 Report, a two-step process is used to attribute profits to a permanent establishment. The first step involves a functional analysis which in the case of business restructuring involving a permanent establishment requires examining whether assets, functions and risks have been transferred to, or from, a permanent establishment. Such transfers will qualify as notional intra-entity transactions. Under the second step, a transfer price must be determined for the transaction using the transfer pricing methods.
5 - The role of the OECD Model Tax Treaty and Commentary
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Summary
Introduction
The foundation of the tax treaty system is the extensive network of tax treaties that has evolved since the work of the League of Nations in the 1920s. The OECD assumed a lead role in guiding the tax treaty system following the disbandment of the League of Nations and its replacement by the UN. The OECD's main vehicle for guiding the tax treaty system norms is the OECD Model and Commentary, together with reports on specific topics. The tax treaties of OECD countries are based on the OECD Model which is the centrepiece of the tax treaty system. As countries vigorously protect their sovereignty and jurisdiction to tax, the implementation of the OECD Model and Commentary in the tax treaties of both OECD and non-OECD countries is a considerable achievement.
This chapter considers the importance of the OECD Model and Commentary in the tax treaty system. OECD countries are expected to base their treaties on the OECD Model, thus the OECD Model and Commentary provides the context in which tax treaties are negotiated by OECD countries. The chapter argues that OECD countries are required to use the Commentary as an extrinsic aid in interpreting their tax treaties and it is also used by non-OECD countries in the interpretation of tax treaties. In Chapter 6 the meaning of former Article 7 of the OECD Model is examined in light of the pre-2008 Commentary and the 2008 Commentary. Chapter 7 studies the issue of deductions for interest on intra-bank loans under former Article 7 by reference to the pre-2008 Commentary.
8 - Intra-bank interest under the 2008 Report
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Introduction
This chapter critically considers measures in the 2008 Report on the application of former Article 7. This chapter shows the OECD's approach to be theoretically flawed, complex and costly to apply to branches of international banks and other international enterprises because they are not separate entities engaging in arm's length transactions with associated enterprises. The interpretation of the arm's length principle advocated in the 2008 Report – called the ‘authorized OECD approach’ – is based on legal fictions and does not reflect business practice. In addition, the OECD's approach may not result in a consensus interpretation of former Article 7 by the OECD countries. Although the OECD has established the authorized OECD approach, it may not be consistently implemented by OECD countries because each country will be acting in its own self-interest. A lack of consensus will inevitably result in double taxation or under-taxation, and disputes with taxpayers. One major issue on which the OECD was unable to establish a single authorized OECD approach was on the method for allocating equity capital to branches of international banks. As a compromise measure, several authorized approaches may be used, but this will lead to double taxation or under-taxation if an international bank's residence country and the host country, in which it has a permanent establishment, use different methods for allocating equity capital to bank branches; resolving the double taxation disputes will be costly and time consuming.
The chapter begins with the allocation of business profits to permanent establishments under former Article 7 of the OECD Model and the adjustment of profits for transactions between associated enterprises under Article 9 as set out in the Transfer Pricing Guidelines. Next the chapter examines the authorized OECD approach for the allocation of business profits to permanent establishments. It then illustrates that the authorized OECD approach is based on the arm's length principle under Article 9 for associated enterprises and that these rules are different to the rules developed under former Article 7 for permanent establishments. The chapter traces the origins of the OECD's transfer pricing rules to the domestic US transfer pricing rules for associated enterprises. The chapter then considers the treatment of a permanent establishment as a functionally separate enterprise under the authorized OECD approach. The chapter examines the measures under the first step of the authorized OECD approach for the allocation of equity capital to bank branches, and the chapter then critically reviews the difficulty of allocating equity capital to bank branches. Finally, the chapter focuses on some of the flaws of the first step of the authorized OECD approach.
1 - Introduction
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Summary
Outline
The importance of bilateral tax treaties has increased significantly over the last sixty years with the extensive integration of national economies and the growth in the number of enterprises operating internationally. The growth in the tax treaty network has been phenomenal and there are presently over 3,000 tax treaties in force. The primary objective of tax treaties is to support international trade and investment by, inter alia, reducing the risk to business of double taxation, resulting from the overlapping of two countries' jurisdictions to tax. Tax treaties deal with the problem of overlapping tax jurisdictions by allocating taxing rights over items of income or taxpayers between the contracting countries. Tax treaties do not create jurisdiction to tax; rather, they allocate taxing rights between the treaty countries to prevent double taxation. International taxation comprises the interaction between the network of tax treaties and the domestic tax systems of countries. Most tax treaties are based on the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention on Income and Capital (OECD Model) and it has become the keystone of the international tax treaty system. Moreover, the United Nations (UN) Model is based on the OECD Model.
A key feature of tax treaties is the allocation of business profits of international enterprises operating globally through permanent establishments under the business profits Article, Article 7 of the OECD Model. This provision became a broadly accepted treaty measure in the early part of the twentieth century when national economies were relatively independent and closed. Globalization has resulted in international enterprises and multinational enterprise groups operating across national borders as highly integrated businesses. International enterprises operate abroad through permanent establishments in host countries. On the other hand, multinational enterprise groups operate abroad through locally incorporated subsidiaries. International enterprises and multinational enterprise groups may use complex financial techniques and sophisticated tax planning arrangements to exploit the deficiencies in the tax treaty system. Former Article 7 has come under increasing pressure through globalization and there was no consensus interpretation of former Article 7 prior to the publication of the Report on the Attribution of Profits to Permanent Establishments (2008 Report) and the adoption by the OECD of the 2008 OECD Model, which incorporated some of the measures from the 2008 Report in the Commentary on former Article 7. A new Article 7 was adopted by the OECD in the 2010 OECD Model which fully implements the principles in the 2008 Report. At the same time, the OECD adopted the 2010 Report which is a revised version of the 2008 Report; the conclusions of the 2010 Report were amended to reflect the drafting and structure of new Article 7. Since 2001, the European Commission has been studying the implementation of formulary apportionment for EU enterprises. The OECD Article 7 reforms and the EU's formulary apportionment proposals are essentially a debate over the relative merits of the arm's length principle as compared with unitary formulary apportionment for allocating the profits of enterprises which operate in more than one country.
6 - Defining the personality of permanent establishments under former Article 7 and the pre-2008 Commentary and the 2008 Commentary
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Summary
Introduction
Former Article 7 establishes a long-standing treaty principle for allocating the business profits of an international enterprise operating through permanent establishments. The rationale underlying former Article 7 is that when an enterprise operates in a host country through a permanent establishment, the enterprise is participating in the economic life of that country. Consequently, former Article 7 allocates to a host country taxing rights over business profits attributable to a permanent establishment in the host country. Former Article 7 is based on the arm's length principle and purports to treat a permanent establishment as a separate entity for the purpose of allocating profits and expenses to it.
Prior to the publication of the 2008 Commentary on former Article 7 there was no OECD consensus interpretation of the provision, despite the revision of the Commentary in 1994. This led to the OECD issuing a series of discussion drafts on former Article 7 resulting in the publication in July 2008 of the ‘authorized OECD approach’ on interpreting former Article 7 – the consensus interpretation – in the 2008 Report. In order to quickly adopt the 2008 Report, the OECD used a two-step implementation procedure, which has created uncertainty. In the first step, in 2008 the OECD amended the Commentary on former Article 7 (2008 Commentary) which implemented the parts of the ‘authorized OECD approach’ in the 2008 Report that do not conflict with the pre-existing version of the Commentary (pre-2008 Commentary). This approach implies that the 2008 Commentary may be used to interpret the business profits Article of tax treaties concluded before July 2008. It is bold for the OECD to claim that the ‘authorized OECD approach’, which is a new interpretation, can be immediately applied to tax treaties finalized before July 2008 on the unconvincing claim that the authorized OECD approach in the 2008 Commentary does not conflict with the pre-2008 Commentary. The authorized OECD approach is a new interpretation of former Article 7 which was established after several years of discussions by OECD countries.
Contents
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Frontmatter
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12 - Conclusion
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International enterprises operating through permanent establishments around the world are difficult to tax at a national level because they operate as unitary worldwide businesses. Any mechanism that seeks to attribute the profits of an international enterprise to a country in which it operates through a permanent establishment will be arbitrary because profits and expenses of an international enterprise do not have geographic indicia, they are merely the profits and costs of the enterprise. Not surprisingly, international enterprises seek to maximize their profits and minimize their tax obligations. International enterprises are able to engage in tax arbitrage by exploiting the differences between tax systems in the countries in which they operate. Tax authorities operate at a national level and cannot realistically rely on the goodwill of international enterprises to comply with tax laws. The present tax treaty system – using bilateral tax treaties and the arm's length principle to allocate business profits to permanent establishments of international enterprises – is fundamentally flawed in theory and practice, and reform has become a pressing issue in the globalized international economy. These flaws have become magnified in the past forty years with the globalization and the rapid global expansion of international enterprises, such as international banks. The flaws in the current tax treaty system have been recognized and debated for some years, the system being described as the flawed miracle. The system is a miracle, in that the tax treaties reflect the OECD Model and it has broad support. But it is flawed, because the system was designed in the early part of the twentieth century and has been eroded by progressive globalization.
This book asserted that the arm's length principle, on which former Article 7 and new Article 7 of the OECD Model are based, is an inappropriate principle for attributing profits to permanent establishments of international enterprises. International enterprises, such as international banks, operate through branches as highly integrated businesses with a common profit motive. Conversely, the relationship between independent enterprises is based on the contracts between them. The assumption that permanent establishments and the other parts of an international enterprise can be treated as separate enterprises operating at arm's length conflicts with the economic theory of the firm and business reality. Thus, the arm's length principle is the wrong norm to use in attributing profits to permanent establishments of international enterprises, such as branches of international banks, because they operate as unitary businesses.
11 - Unitary taxation
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Introduction
Developments in communications and information technology have provided international enterprises with the capacity to operate internationally, through either subsidiaries or branches, as highly integrated businesses. Allocating the profits of these international enterprises to the jurisdictions in which they operate for tax purposes is a complex issue. The reason this task is so challenging is that the profits of an integrated international enterprise have no geographic source. The OECD Model and its Commentary use the arm's length principle to allocate profits between associated enterprises operating internationally or within international enterprises operating abroad through branches. Globalization has created an integrated international economy, and the implications of this development for the international tax rules are profound.
An alternative method of allocating profits from international transactions to jurisdictions is unitary formulary apportionment, which treats an international enterprise operating through branches or a group of companies as a unitary business. Unitary formulary apportionment avoids the problems of assuming the economic independence of each part of an international enterprise and the problems of transfer pricing which are inherent in the current tax treaty system. While unitary formulary apportionment overcomes some of the problems associated with the arm's length principle, it also has a number of shortcomings. Moreover, unitary formulary apportionment has not been tested at an international level. The European Union (EU) has recognized the flaws in the bilateral tax treaty system and in transfer pricing, and the European Commission is considering comprehensive reform measures, such as implementing a multilateral tax treaty using formulary apportionment. This is an exciting and promising prospect for international tax reform.
7 - Intra-bank loans under the pre-2008 Commentary and 1984 Report
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Globalization has led to international banks operating through foreign branches, significantly expanding the scope and scale of operations of such banks. Since the 1990s, most developed countries allow international banks to operate through branches rather than requiring them to establish locally incorporated subsidiaries. But it is a challenging task for an international bank to attribute business profits to its branches for tax treaty purposes. A key factor in determining the business profits of a branch of an international bank is the deductibility of interest on intra-bank loans, which are a major source of funds for branches of international banks. Former Article 7 (Article 7 of the 2005 OECD Model and Commentary (pre-2008 Commentary)) and pre-2008 Commentary contain principles on the deductibility of interest on intra-bank loans. In 1984 the OECD published Transfer Pricing and Multinational Enterprise (Three Taxation Issues) (1984 Report) which deals, inter alia, with the allocation of business profits on intra-bank loans to branches of international banks. Together, the views expressed in the pre-2008 Commentary on former Article 7 and the 1984 Report represent the OECD principles on the allocation of business profits on intra-bank loans to branches for most treaties completed before July 2008.
The OECD has recognized the need to revise the international tax principles for determining the business profits of branches of international banks and other permanent establishments under former Article 7. In 2001, the OECD released a Discussion Draft on the Attribution of Profits to Permanent Establishments (2001 Discussion Draft) containing proposals for attributing profits to a permanent establishment under former Article 7 of the OECD Model. The objective of the proposals was to establish a consensus interpretation of former Article 7. The 2001 Discussion Draft contained two parts, Part I setting out the proposed measures and Part II applying them to branches of international banks. In 2003 the OECD released a revised Part II of the Discussion Draft (2003 Discussion Draft). The proposals in Part II of the 2003 Discussion Draft were designed to replace the 1984 Report. A feature of the proposals is to treat a branch of an international bank as a distinct and separate bank. In 2008, the OECD published the 2008 Report and the 2008 OECD Model with a revised Commentary on former Article 7 (2008 Commentary). The 2008 Commentary incorporated part of the 2008 Report. Part II of the 2008 Report (Special Considerations for Applying the Authorized OECD Approach to Permanent Establishments of Banks) replaces the 1984 Report and was incorporated in the 2008 Commentary. But the 1984 Report may be used for the numerous tax treaties which were concluded before 22 July 2008. Although some countries may seek to apply the 2008 Commentary to treaties concluded before 22 July 2008, other countries may not take that approach, as the changes to the 2008 Commentary were significant and it would be inappropriate to apply these changes to treaties concluded before 22 July 2008. As some tax treaties concluded before 22 July 2008 were negotiated in anticipation of the 2008 Report, it may be appropriate to use Part II of the 2008 Report in applying former Article 7 and the 2008 Commentary to branches of international banks.
10 - New Article 7 of the OECD Model and Commentary
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Introduction
In 2008, the OECD published the 2008 Report which established the authorized OECD approach for determining the profits that are attributable to permanent establishments under Article 7 in light of modern multinationals. The 2008 Report is based on the principle of applying by analogy the guidance in the Transfer Pricing Guidelines for the purposes of attributing profits to permanent establishments. Moreover, the 2008 Report claimed that there is broad consensus within OECD countries that the principles in the 2008 Report are better than the approach for attributing profits to permanent establishments expressed in the pre-2008 Commentary on former Article 7. The approach developed by the OECD in the 2008 Report was not restricted by the original intent of former Article 7, or by any historical practice and interpretation of former Article 7, as the OECD acknowledged that prior to the publication of the 2008 Report there was no consensus interpretation of former Article 7 in OECD countries.
The OECD claimed in the 2008 Report that the best way to provide tax authorities and taxpayers with certainty on attributing profits to permanent establishments is to replace former Article 7 with a new version of Article 7 which reflects the principles in the 2008 Report. The new version of Article 7 was adopted in 2010 and at the same time the OECD adopted and published a revised version of the 2008 Report, the 2010 Report, ‘to ensure that the conclusions of that report could be read harmoniously with the new wording and modified numbering’ of the new Article 7. The conclusions in the 2010 Report are identical to those in the 2008 Report, but the 2010 Report reflects the drafting of new Article 7. New Article 7 reflects the principles adopted in the 2010 Report and ‘must be interpreted in light of the guidance contained in it’. The aim of the OECD is to prevent the past interpretations of former Article 7 from being applied to the new provision.
Bibliography
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Index
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3 - Some shortcomings of the tax treaty system
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Summary
Introduction
This chapter surveys two aspects of the current taxation of cross-border transactions: international tax avoidance, and problems in the operation of bilateral tax treaties. The chapter argues that there is a need for international tax reform in response to the globalization of international trade. The chapter focuses first on international tax avoidance, and outlines the ability of international enterprises to avoid taxation through sophisticated tax planning techniques. A major form of international tax avoidance by international enterprises is transfer pricing manipulation by associated enterprises. Transfer pricing anti-avoidance measures, in tax treaties and domestic legislation, are based on the arm's length principle. The chapter considers transfer pricing manipulation and examines the difficulties of applying the arm's length principle to transactions between associated enterprises. While the appeal of the arm's length principle is that it is theoretically straightforward, it has proven very difficult to apply in practice.
The chapter considers some of the problems created by the current international tax measures. The main flaw with these measures is that they do not provide a framework for the coordinated and measured implementation of tax policies and practices developed through the multilateral negotiations of countries. The current international tax treaty system is focused on removing obstacles to international trade and investment by, inter alia, allocating taxing rights between two countries. As the network of tax treaties has expanded, it has proved to be unwieldy and exceptionally difficult to reform. Meanwhile, international enterprises operate integrated global businesses and are able to exploit the current tax treaty system to avoid taxation. The chapter concludes with a brief consideration of the obstacles to international tax reform.
International Taxation of Permanent Establishments
- Principles and Policy
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The effects of the growth of multinational enterprises and globalization in the past fifty years have been profound, and many multinational enterprises, such as international banks, now operate around the world through branches known as permanent establishments. The business profits article (Article 7) of the OECD model tax treaty attributes a multinational enterprise's business profits to a permanent establishment in a host country for tax purposes. Michael Kobetsky analyses the principles for allocating the profits of multinational enterprises to permanent establishments under this article, explains the shortcomings of the current arm's length principle for attributing business profits to permanent establishments and considers the alternative method of formulary apportionment for allocating business profits.