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Quarterly tax treaty briefing: Autumn 2016

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A treaty non-discrimination article may protect against host country tax liabilities that would otherwise arise as a result of a merger, reorganisation or branch incorporation. Based on a substantive and functional, rather than legal, approach, the Spanish Supreme Court has affirmed the decisions of lower courts that Dell’s Spanish commissionaire agent constituted a PE of its Irish principal. Spanish courts have tended to follow this approach in contrast to other jurisdictions, such as France, Italy and Norway. Payments for website hosting and other technological activities, as well as for commercial knowhow, may attract treaty withholding tax, depending on whether they constitute a royalty or a service and taking into account treaty definitions. New treaties should be carefully scrutinised for provisions based on BEPS Actions 6 and 7, which may curtail access to treaty benefits.

This article provides a quarterly update on tax treaty developments.

Taxing a merger is discriminatory

The decision of India’s Authority for Advanced Rulings (AAR) (No. 1130 of 2011) once more illustrates the significance of a treaty non-discrimination article. 

Broadly, the facts were as follows. Banca Sella Holding SpA (BSH) was an Italian bank with an Italian subsidiary, Banca Sella SpA (BSS). BSS and BSH jointly owned another Italian company, Sella Servizi Bancari SCPA (SSB) with a branch office in India. In 2011, SSB was merged with BSS, the survivor company. As consideration, BSS issued shares to BSH. As a result of the merger, the Indian branch office was effectively transferred to BSS.

The Indian tax authorities asserted that the merger resulted in a taxable transfer of SSB’s Indian branch, resulting in a gain taxable under art 14.2 of the India/Italy treaty. However, Indian domestic legislation provides that transfers of capital assets in a merger are tax- exempt, as long as the new company is an Indian company. The AAR held that this requirement was discriminatory under art 25.1. It provides that nationals of a contracting state (in this case, Italy) are not to be subjected in the other contracting state (India) to more burdensome taxation than nationals of that other state in the same circumstances.

The tax authorities also asserted that BSH’s receipt of the BSS shares in the merger resulted in a taxable gain. Apart from the fact that the shares in question were shares in an Italian company transferred outside India, article14.5 of the treaty restricted India’s taxing rights to the transfer of shares in an Indian company.


A decision based on broadly the same circumstances was given by the Finland Supreme Administrative Court on 25 October 2013 in case no. KHO 2013:169. In a standard branch incorporation, a US company’s Finnish branch was transferred to a Finnish subsidiary in exchange for shares issued to the US company. Under Finnish domestic law, this transaction would have been tax free had the transferor company been Finnish. Because it was not, the tax authorities asserted that the gain arising was taxable to the Finnish branch. However, article 24.2 of the Finland/US treaty provided that the taxation of a PE in a host state (Finland) should not be less favourably levied than the taxation levied on enterprises of that state carrying on the same activities. Accordingly, the court held that the treaty required that the branch incorporation be tax free.

It is interesting the Finnish decision looked to the discrimination of PEs (Model article 24.3), whereas the Indian decision was based on the discrimination of nationals (Model article 24.1). This may be because the Indian merger did not involve an active disposal of the assets by the PE, but rather a merger under which its assets were transferred by operation of law.

There are probably other jurisdictions where domestic law provides that a branch incorporation or merger is taxable if a non-resident is a transferring party. A treaty non- discrimination article could result in tax freedom.

Spanish Commissionaire was PE of Irish principal

The Spanish Supreme Court has approved the decisions of the lower courts Dell Spain 1475/20160, which held that Dell’s Spanish subsidiary constituted a PE of its Irish affiliate (see ‘Quarterly tax treaty briefing: Spring 2016’, Tax Journal, 15 April 2016).


Previous Spanish Supreme Court decisions have reflected the same approach, i.e. Roche Vitamins Europe SA (Case 1626/2008) and Borax Europe Ltd (Case 1933/2011). The courts have adopted a functional and substantive approach to commissionaire arrangements. This contrasts with decisions in the opposite direction under which a commissionaire agent was held not to be a dependent agent in cases adopting a more legalistic approach, such as Zimmer SAS (French Supreme Court, Case 304715), Boston Scientific (Italy Corte di Cassazione, 29 February 2012) and Dell Norway (Supreme Court of Norway Case 2011/755).

In any case, the argument will become archaic once the dependent agent article of tax treaties follows the recommendation in BEPS Action 7 that a dependent agent includes one whose principal role leads to the conclusion of contracts without material modification. This recommendation is already followed by Chile’s treaties with Argentina, China, Japan, Italy and Uruguay; India’s treaties with Kenya, Korea and Thailand; and the Australia/Germany and Costa Rica/Mexico treaties.

Companies with existing commissionaire arrangements, especially those in Spain, need to be particularly wary in light of the attitude of the Spanish courts and any upcoming treaty amendments.

Upcoming consequences of BEPS Action 6

Action 6 is likely to result in a considerable number of new treaty provisions. Two of these are discussed here.

 A new model art 3 will include a definition of ‘special tax regime’ that provides a preferential tax rate to specific items of income. This includes a notional interest deduction. New provisions will be included in model arts 11, 12 and 21 to deny lower treaty rates to residents benefiting from such regimes who receive interest, royalties or other income from the source country. Assuming a treaty that reflects this, it is likely that a Belgian company entitled to a notional interest deduction (as most Belgian companies are) will be denied treaty withholding tax reductions for interest, royalties and other income receipts. (Notional interest deductions also apply, or are proposed, in Cyprus, Italy and Turkey.) Model art 3 is to include an exemption, inter alia, where the relevant legislation or regulation satisfies a substantial activity requirement, but it is unclear whether this could be applied to a company’s notional interest deduction.

A new Model article 1.3, based on US treaty ‘savings clauses’ will allow a state to tax its residents despite the terms of the treaty. This is aimed at arguments limiting a state’s right to tax its residents; for example, limiting a resident state’s taxing rights under its controlled foreign company rules (as in France, Schneider Electric(2002) Case T-310/01 and Brazil, Eagle Distribuidora de Bebidas S/A (2008). Paragraph 23 of the commentary on art 1 of the model treaty disputes this assertion and the proposed ‘savings clause’ strengthens this.

However, there are a number of exceptions to the imposition of the proposed ‘savings clause’, including treaty exemptions designed to avoid double taxation (Model article 23A). This is illustrated by the following example.

A Luxembourg company derives a gain from Hong Kong real estate. Article 13.1 of the Hong Kong/Luxembourg treaty allows Hong Kong to tax the gain, even though it does not tax capital gains. Article 22.2(a) aims to eliminate double taxation by exempting from Luxembourg tax that income which the treaty allows to be taxed in Hong Kong (Luxembourg taxes gains as ordinary income). As a result, the gain is taxed in neither jurisdiction. A ‘savings clause’ added to the treaty based on Action 6 would not restore Luxembourg’s taxing rights because of the model art 23A exception for double tax relief; however, a ‘subject to tax’ condition would. In other words, art 22.2(a) could be amended so that Luxembourg would only exempt the gain provided it was taxed in Hong Kong.


New treaties should be carefully scrutinised for provisions based on Action 6 (or 7 in the case of PEs) that may curtail access to treaty benefits.

Website hosting

Previous tax treaty briefings have discussed the nature of payments related to computer technology. In particular, para 14 of the OECD commentary on the model treaty art 12 specifies that payments to a provider which enable the user to operate the computer program constitute business income taxable under art 7, and so are tax exempt in the host country in the absence of a PE there. Essentially, this represents the provision of a service into which the copyright is embedded. (In contrast, para 13.1 makes it clear that payments for the right to reproduce and distribute the program represent payments for the copyright of the program, which are taxable as a royalty under art 12.) Interestingly, para 28 of the commentary contains the reservation that Mexico, Portugal and Spain hold the view that payments relating to software constitute copyright royalties within art 12.2 of the model treaty, if the software is not standardised but is adapted to the purchaser.

In fact, the Spanish tax authorities appear to have departed from their reservation in a recent ruling (No. V0799 16). This related to a Spanish company’s payments to a US company under a website hosting agreement, under which the US company provided hardware and software for its flight booking webpage. The package comprised a standard system used by other companies in the transport industry but the Spanish company was naturally permitted to customise it by introducing its own pictures, designs, etc. However, it was specifically prohibited from copying the program. This modification right clearly fell within Spain’s commentary reservation that payments involving adapted software constitute royalties. However the tax authorities’ ruling classified the payments as business profits. In contrast, previous rulings had adhered to the commentary reservation in holding that payments for customised software were copyright royalties that would have been subject to a 5% withholding tax under art 12.2(a) of the Spain/US treaty. 


As always, the terms of a software licensing agreement and the relevant domestic, treaty and case law require careful review in determining whether the relevant income constitutes a copyright royalty based on art 12.2 of the model treaty.

In fact, a website hosting case was also recently decided by the Mumbai bench of the Income Tax Appellate Tribunal (ITAT), in the case of DDIT v Savvis Communication Corporation (ITA No. 7340/Mum/2012), although the technical grounds differed from the Spanish case. With the help of sophisticated equipment, Savvis provided web hosting services to two Indian companies in return for fee payments. The Indian tax authorities asserted that the fees were payment for the right to use the equipment and so subject to 10% withholding tax under art 12.2(b) of the India/US treaty. Unsurprisingly, the ITAT sided with the taxpayer in ruling that the services provided involved the use of equipment but the taxpayer did not have access to it; and so the payments made were not made for its use.    

Commercial knowhow is a royalty

The case of TNT Express Worldwide (UK) Ltd. v DDIT (ITTPA No.6/Bang/2011) serves as a reminder that treaty royalty definitions are wide in ambit and also underlines the treatment of composite payments.

TNT is a UK company engaged in the business of freight, parcel and document distribution. It entered into a management services agreement with its Indian subsidiary to provide it with a wide range of services, including management, financial and administrative support, automated process and system services. The Indian tax authorities asserted that the payments under the service agreement were royalties within Indian domestic law and art 13.3(a) of the India/UK treaty, being payments for information concerning industrial, commercial or scientific experience; in other words, commercial knowhow. The management, financial and administrative services element of the package did not fall into this category but the rest of the elements did. However, TNT failed to produce information which segregated the various elements of the service agreement. The tribunal therefore treated the entire payments as royalties subject to withholding tax under article 13.2 of the treaty, basing its decision on para 11.6 of the OECD commentary on article 12 of the Model treaty, that the principal purpose of the services agreement was the provision of commercial knowhow.  


It is sometimes overlooked that information such as commercial knowhow falls within the treaty and domestic law definition of royalties subject to withholding tax.                                              

Recent treaty highlights


The Australia/Germany treaty includes collective investment vehicles as treaty residents in defined circumstances.


Preparatory and auxiliary: The Australia/Germany treaty follows the BEPS Action 7 recommendation in conditioning the preparatory and auxiliary exemptions on being of a preparatory or auxiliary character (and thus not core to the business).

Anti-fragmentation: The Australia/Germany treaty also includes the recommended BEPS Action 7 anti-fragmentation recommendation that the exemptions shall not apply where the overall activities of the enterprise and closely related enterprises fail the preparatory or auxiliary test, provided that they constitute complementary functions that are part of a cohesive business operation.

Splitting up contracts: Following the Action 7 recommendations, the Kazakhstan/Serbia treaty provides for the activities of associated enterprises to be linked in calculating the more than 183 day test for the establishment of a services PE in the host state. 

Stock of goods as PE: The Albania/Morocco, Czech Republic/Turkmenistan, Ethiopia/United Arab Emirates, Hong Kong/Russia, India/Kenya, Malaysia/Slovak Republic, Malta/Vietnam, Oman/Portugal, Morocco/Saudi Arabia, Portugal/Saudi Arabia, Portugal/Vietnam and Uruguay/Vietnam treaties deem there to be a PE when a dependent agent habitually maintains a stock  of goods delivered on behalf of a non-resident principal.

Dependent agent: Following BEPS Action 7, the Australia/Germany, Chile/Argentina, Chile/China and Iceland/Liechtenstein treaties include as a PE a dependent agent that habitually plays the principal role leading to the conclusion of contracts. The India/Kenya treaty similarly deems there to be a PE when a dependent agent habitually secures orders.

Insurance enterprise:  Morocco’s treaties with Albania and Saudi Arabia specify that a dependent agent of an insurance enterprise is deemed a PE if it collects premiums or insures risks (other than reinsurance) in the host state.

Operation of equipment: The Argentine/Chile and Australia/Germany treaties  include as a PE the operation of equipment for more than 183 days in any 12 month period.

Toll manufacturer: The Australia/Germany treaty includes  as a PE a person who manufactures or processes in a contracting state for a foreign enterprise goods or merchandise that belong to it.

PE profit allocation: the AOA approach

The Andorra/Liechtenstein, Armenia/Sweden, Belgium/Switzerland, Cyprus/Jersey, Germany/Japan, Iceland/Liechtenstein and UAE/Liechtenstein treaties allocate profits to a PE based on the 2010 authorised OECD approach (AOA), in particular taking into account the PEs functions, assets and risks.

The Belgian Ministry of Finance has published a draft circular on profit allocation to a PE, based on the OECD report on the AOA approach. It contains various calculation examples.

Dividends and interest

The protocols to Germany’s treaties with Australia, Costa Rica and Finland provide that the source country may fully tax deductible dividends and profit- sharing  interest(including a silent partner’s profit share), that have been deducted from profits, provided they are derived from rights or debt claims carrying a right to profit participation.

Capital gains

The Indian government has approved a protocol to its treaty with Cyprus that will grant India the taxing rights over a Cypriot resident’s gains realised on shares in Indian companies (see ‘Quarterly tax treaty briefing: Summer 2016’, Tax Journal, 22 July 2016).

Mutual agreement procedure

The Australia/Germany, Colombia/France, Cyprus/Jersey, Germany/Japan, Iceland/Liechtenstein and UK/Uruguay treaties include an arbitration clause designed to speed up the MAP process.

Most favoured nation

A protocol to the Cyprus/Ukraine treaty provides that, if Ukraine signs a treaty with another country providing for lower tax on dividends, interest or royalties, or more favourable treatment of capital gains, then the two states have the right to renegotiate the treaty accordingly.

Anti-abuse developments

LOB: Chile’s treaty with Argentina and Germany’s treaty with Japan both include detailed LOB provisions based on the BEPS Action 6 recommendations.

Special tax regimes: Based on the BEPS Action 6 proposals for inclusion of ‘special tax regimes’ in Model article 3, the Saudi Arabia/Sweden treaty includes a provision denying treaty benefits to banking, shipping, financing, insurance and headquarter companies enjoying  a significantly lower tax rate in their state of residence.