11 December 2015

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Critical evaluation of the plans to introduce a tax on the United Nations Model Tax Convention of the new article that permits the withholding tax to be charged on payments to non-residents of fees for technical services.

Global trade in services increases and the efficient and effective taxation of income generated by those services is becoming an increasingly important issue. Source countries generally cannot tax technical services under the current provisions in the United Nations Model Double Taxation Convention. This leads to a prima facie tax avoidance by Multinational Enterprises from fees collected for technical services.

Article XX in the United Nations Model Tax Convention (thereinafter referred to as «UN MTC») purports to permit withholding tax to be charged for technical services for payments to non-residents. Services are generally exclusively taxable by the residence state. The new article follows the principle that the country from which payments are made will be entitled to tax such payments on a gross basis without any threshold as to the presence in the country, irrespective of whether services are rendered within or outside the country. The term “payments for technical services” means “any payment made for any service of a managerial, technical or consultancy nature”. Modern means of communication and information technology is an easy way for an enterprise in one Contracting state to provide services in other Contracting state without any significant presence in that other state in order Permanent Establishment (PE) rules to be applied.

The OECD Model Tax Convention (OECD MTC) and the UN MTC, do not have any specific article dealing with technical services fees. In the OECD MTC technical service fees are considered to be business profits and are taxable in the country of residence of the enterprise, unless that enterprise has a PE in the source state. This provision gives the right to the source country to tax any profits arising in its territory from a non-resident enterprise. The UN MTC contains a similar rule. However it also contains “the force of attraction” principle, which has not been included in the OECD MTC. Article 14 of UN MTC, which concerns income from independent personal services, can also be applied on technical services fees. However, technical service fees within the scope of this article are taxable only in the state where the provider is resident, unless he has a fixed base in the source state or complies with the condition to have PE. Generally speaking, the source states will have right to tax technical services under the article of PE on both UN and OECD Conventions.

However, in many instances businesses may have significant amounts of profits arising from technical services without creating PE. When the fees are paid by an enterprise which is resident to the source country, that country will lose revenues from taxes as it will have to deduct the expenses paid by the resident. Therefore, some states prefer to negotiate separate rules, which will allow them to tax technical services. For that reason, newer tax treaties contain rules that increase the likelihood that the source states may tax technical services fees.

The income from services provided to a customer in another country can be treated in three ways. Firstly, the service provider will have a fixed place of business in the host state from where the business is wholly or partly carried out or he will have a dependent agent in the host state. Secondly, the definition of income from services as business profits would normally specify those services. If the income does not breach the threshold of PE, then it will not be taxable by the host state. Finally, services income would either be dealt as part of royalties’ article or in a separate article which will permit withholding tax on the gross amount on a specified rate.

Taxation of services should be fair to both source and residence country. The most fundamental principle underlying the taxation of services is the source principle. Only income from services performed by a resident of one country in another country is taxable by that other country. But many services which generate income and are performed outside the source country are not taxable by that country, even if those services provide benefits to or are utilized by residents of that country. Consequently, many bilateral tax treaties have included fees for technical services, especially between developing countries. Many special provisions dealing with technical fees only require for source country tax payment of an amount for technical or consultancy services by a resident of the source country to a resident of the other country. It is not necessary for the services to be provided in the source country. In these provisions, the base erosion principle trumps the source principle. It has been said that this is an inappropriate and unprincipled extension of source country taxing rights that should not be adopted by the UN MTC.

The OECD MTC has been criticized as not being fair to developing countries. In the real world, the residence country is generally a developed country, and source country is a developing country. Therefore, the UN MTX basically lowered the threshold of activity that can trigger taxation in the source country, and left it open to residence countries to determine the rates of withholding on interest dividends and royalties.

Many UN member states hold the opinion that the division between “source” and “residence” principles needs to be rebalanced in favour of “source” countries. The two approaches UN has identified in order to increase “source” country taxation are to broaden the definition of PE so it can minimize the threshold for creating PE or to impose withholding tax on payments for technical services. It has been supported that, potential rebalancing of competing interests by a possible change to the UN MTC, might have several material consequences for world trade and direct investments but it would work more sufficiently an adequately working dispute resolution mechanism about double taxation.

Withholding tax is negatively criticised because it shifts the risk for double taxation or it provides unreasonably high tax burdens to the taxpayer. Moreover, fees for providing technical services include significant expenses; therefore withholding taxes is not effective for such activities. This tax normally exceeds the normal net profit of services transactions and will often result in raising the cost to the purchaser of the services in the taxing jurisdiction. It would also create economic distortions which could restrain such purchasers’ access to the most competitive and efficient services. For these reasons, any gross basis withholding tax should be set at a reasonable level. There are concerns that this new article might be used to levy withholding taxes on any fee paid from a country. For that reason, it is been proposed that article XX would most appropriately be placed as an exception to the general principle of PE.

Developing countries face difficulties in collecting tax from non-residents such as difficulty to tax income derived from services performed by non-residents because of weak tax administrative capacity, system design and operation. They also face problems in relation to international developments. These difficulties may justify source countries imposing tax on a gross basis, assuming that the rate of tax is limited. They may also justify special provisions with regard to non-arm’s length payments for technical, management and other services performed by a non-resident parent corporation for a related company resident in the source country. In the absence of special provisions, the only protection against the erosion of the source country’s tax base would be the application of the source country’s transfer pricing rules.

However, it should be noted that these rules are notoriously difficult for the tax authorities of developing countries to apply effectively.In India for instance, tax foreign service providers who offer services in the country regardless of where these services are performed or the location of the person paying for them, there are difficulties in levying this tax because the authorities need to be aware of any arrangements between the parties. If the payment has not been made from India, there is limitation on the actions it can take to physically collect the tax. Withholding tax can be imposed if the payment is made from the country of residence of the company or individual and it will be imposed on the payment made to the service provider. That capacity of withholding tax makes it an attractive collection mechanism because it is very easy to be imposed and collected despite the negative criticism.

Furthermore, problems can arise between royalties and technical services fees. The term “royalties” is the return in a licensing transaction from the licensee to the licensor of Intellectual Property Rights. However, the definition of royalties for tax purposes is primarily to be found in the income tax legislation of each state, in addition to tax treaties. Royalties can include services and those services can attract the same withholding of taxes as royalties. Payments, in respect of development or amendment of a model, plan, secret formula which can result in the gaining of information concerning commercial or scientific experience, will be difficult to assert if the payment constitutes royalty. This problem exists even if, for example, the developer contracts to retain all rights in intellectual property once developed. The Commentary on article 12 of OECD MTC analyses that act of development of previous knowledge constitutes service. Particular problems are created from the know-how of intellectual property as it could be considered as previous knowledge. Paragraph 11.3 of the Commentary on Article 12 offers some criteria to distinguish know-how and services contracts. These criteria however helpful they might be do not adequately reflect the problem as many contracts are mixed up and unclear in relation to the terms of supply of know-how and services.

A contemporary problem addressed by OECD in BEPS 2014 is the intangibles in the perspective of the digital economy which is combined with the mobility of intangibles for tax purposes under existing tax system. Payments for technical services are often deductible against a country’s tax base if the tax payer is resident or non-resident with PE or fixed place of business. As a result, this generates important BEPS opportunities in the area of direct taxes. The ability to centralise infrastructure at a distance from a market jurisdiction and carry out the business of sales of goods and services into that market from a remote location, combined with increasing ability to conduct its major part of business with minimal use of personnel and other resources, generates potential opportunities to achieve BEPS by fragmenting physical operations in order to avoid taxation. New ways of carrying out business, give rise to questions about whether current nexus rules continue to be inappropriate. Digital technology has major impact on how business activities such as customer support, marketing and advertising are carried out. Today it is possible to be actively involved in the economy of another country without having a permanent place of business or a dependent agent therein, and concerns have been raised regarding whether the existing definition of PE remains consistent with the underlying principles on which it was purported to be based. If it is possible a country to tax a non-resident service provider, the reduction of the country’s tax base by the deductible payments will be counterbalanced by the country’s tax on these payments.

Such provisions in tax treaties dealing with technical services fees indicate that withholding tax for such services with a limited tax rate by the source countries, is a desirable and acceptable action for both of the resident countries and source countries. Consequently it can be argued that taxation of income derived from technical services on a net basis in source countries is not immutable. Therefore, taking into account the development of the technology of information, and the existence of cyber-based services to consumers as a substitute for the factors of physical presence in the term “fees for technical services”, the existing separate provision in some treaties dealing with fees for technical services could be used to deal with fees for cyber-based technical services.

To conclude, the recent advancement of telecommunications has brought new means of operating business and law should pace with them. The new article in the UN MTC has been criticised that it will provide high tax burdens to the tax payer and also critics arise in terms of interpreting it. However, it is an easy way for developing countries to tax profits from non-residents and an effective way to avoid a country’s tax base erosion.

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