Double taxation treaties & their implications for investment: what investment policymakers need to know (UNCTAD Guidance – 2024)

Herreveld Van den Hurk & Partners (www.hhp.law ) is a boutique advisory firm with an interdisciplinary team of top specialists in tax strategies, tax controversies and risks in international and European taxation. These specialists have a focus on direct and indirect taxation, on international law and investment treaties, and on formal law (as attorneys-at-law).

Expertise on both international taxation and investment treaties is a logical combination for tax dispute resolution. Often, claims of foreign direct investors against a State under an investment treaty concern the behavior by its tax authority that conflicts with its substantive obligations under the investment treaty, such as the requirement of fair-and-equitable treatment and full compensation in case of (in)direct expropriation.? Foreign direct investors can also pursue tax dispute resolution options under national legislation or double taxation agreements. A good understanding of all available options is particularly important for consultants, when providing a balanced advise to clients, who make cross-border investments and seek optimal protection of their investments from various forms of risk, including tax risks.?So, the team of HHP team is properly balanced, to be able to assist such clients and their regular legal and tax advisors, in this very respect.

Recently UNCTAD published a guide on double taxation treaties (DTTs) and their implications for investment policymakers which complements the guide on international investment agreements and their implications for tax measures , published in 2021 by UNCTAD in cooperation with the WU Global Tax Policy Center.

EXECUTIVE SUMMARY: WHAT INVESTMENT POLICYMAKERS NEED TO KNOW ABOUT DTTS

Double taxation treaties (DTTs) are international agreements, almost exclusively concluded on a bilateral basis, that aim to alleviate double taxation arising from cross-border business activities. They do so by distributing taxing rights over different items of income or capital between the contracting States. At the same time, DTTs aim to prevent instances of their improper use for the purpose of tax evasion and avoidance. They are the central pillars of international tax coordination and despite their bilateral nature and divergent details, they all follow the same overall patterns determined by model conventions put forward by the United Nations and the Organisation for Economic Co-operation and Development (OECD).

The overarching goal of DTTs is to facilitate cross-border business activities, trade and investment, by preventing the double taxation that such activities might be subject to, while creating a level playing field. Given the material impact that DTTs can have on investment, it is important that investment policymakers understand their main features and are able to engage in debates related to different DTT policy options.

This guide focuses on the most relevant features of DTTs. It revolves around what investment policymakers need to know about the different DTT design options, considering their investment implications. By doing so, it also aims to stimulate interaction between investment and tax policymakers. Alongside the guide on international investment agreements (IIAs) and tax measures (UNCTAD, 2021), this guide aims to allow the two communities to share expertise and ensure more coherent approaches to tax and investment policymaking with a focus on reformed options.

Personal scope of DTTs

An individual or legal person who is a resident in one or both contracting States may have access to DTT benefits. These conditions leave room for opportunities of jurisdiction shopping and allocation distortions. The international tax system has developed several tools to counter abusive practices at both the domestic and the DTT level. The anti-avoidance rules vary in complexity. Although more complex rules provide greater legal certainty for investors, they are more difficult to administer by tax authorities, which can be a challenge for jurisdictions with limited administrative capacity.

Taxes covered

DTTs generally cover direct taxes on income and capital. They do not cover indirect taxes or levies that are not considered taxes in the strict sense, such as social security contributions. Some types of levies, such as digital services taxes, may be specifically designed in a way that leaves them outside the scope of DTTs. The vast majority of DTT provisions, including those on relief from double taxation, only apply with respect to covered taxes. Finally, the international tax system leaves a legal vacuum with respect to the coordination of value added tax (VAT), one that could be filled by regional economic integration organizations.

Attribution of taxing rights over active business income

DTTs attribute taxing rights over active business income to the residence jurisdiction unless the enterprise has a physical presence (a permanent establishment) in the source jurisdiction. The physical presence test makes it possible for an online business to trade with or do significant business in a country without triggering compliance obligations for corporate income tax purposes, which is important from a trade and investment policy perspective. When deciding on the scope of the definition of a permanent establishment, it is important to keep in mind that the broader the criteria (i.e. the easier it is to trigger the permanent establishment threshold), the more foreign investors will be affected, including smaller ones. Hence, while the broadest possible definition may be appealing from a tax revenue perspective, it must be balanced against its investment implications. Certain types of business activities may not take place in a jurisdiction if they trigger a permanent establishment and the concomitant compliance costs outweigh the business rationale.

Attribution of taxing rights over passive business income

DTTs allow source jurisdictions to tax passive business income derived from dividends, interests, and royalties under certain circumstances even where the enterprise has no permanent establishment in its territory. The tax is generally levied on a gross basis, by means of a withholding tax (WHT), and up to the amount of a cap established under the applicable DTT. The residence State can then also tax the income but must alleviate any double taxation that arises. WHT is collected by the payer, acting as a withholding agent, simplifying tax enforcement for non-residents. WHTs are, thus, a convenient way for source countries to raise revenue, and they are easy to administer. The application of a gross basis WHT may have some distorting effects in certain situations as it may represent an entry barrier or lead to taxation of loss-making entities. WHT rates vary across DTTs, creating incentives for treaty shopping.

Attribution of taxing rights over personal income

DTTs attribute the taxing rights over personal income exclusively to the State of residence of the worker or self-employed person, unless the individual has a significant physical presence in the source State. These rules were developed before the spread of mobile and remote working. In the context of remote working, they can lead to a misalignment between where taxing rights are attributed and where the proceeds of work are enjoyed. Remote working arrangements allow firms access to foreign labour without the need to invest in an overseas jurisdiction. Such arrangements also allow firms to rely on independent rather than employed workers and to pass foreign tax and social security responsibilities on to the self-employed. Trade and investment policymakers should be aware of taxing rights applicable to remote working arrangements.

Methods for elimination of double taxation

DTTs either exclusively attribute taxing rights to one of the contracting States or they provide both States with the possibility to tax, and the State of residence is obliged to provide relief from double taxation. This relief takes the form of either the exemption of the foreign income from the domestic tax base or a credit for the taxes paid abroad. The policy choice depends on whether the State in question wishes to ensure neutrality in the source State where the investment is located (exemption method) or in the residence State of the investor (credit method). From an investment policy perspective this choice can have important consequences as it affects, among others, the treatment of foreign tax incentives.

Anti-abuse provisions

DTTs include anti-abuse provisions to curb treaty shopping and tax avoidance arising from the improper use of tax treaties. States have three options: (i) a principal purpose test (PPT) provision, (ii) a combination of a PPT provision and a limitation of benefits (LoB) rule or (iii) an LoB provision together with a rule against conduit arrangements. These rules were implemented as a result of the OECD/G20 Base Erosion and Profit Shifting Project and are treated as minimum standards. The choice of one of the three anti-abuse options depends on the contracting States’ perceptions of their needs and bargaining positions. The PPT is simpler to implement but may give tax authorities a greater deal of discretion, which brings uncertainty to taxpayers. A LoB clause provides more predictability and legal certainty to taxpayers, but it is more complex and may present challenges for tax administrations that have capacity constraints.

Non-discrimination

DTTs provide for non-discriminatory treatment in specified scenarios. Investment policymakers should take note of the key differences between non-discrimination in DTTs and the concept of discrimination in international trade and investment agreements. Most importantly, the non-discrimination provision in a DTT applies on the basis of residence whereas in investment and trade agreements such provisions generally apply on the basis of nationality, leading to a potential mismatch between the different types of treaties.

Dispute resolution

DTTs contain a system for dispute settlement that differs from the investor–State dispute settlement mechanism used in IIAs. In tax disputes under DTTs, taxpayers are never direct participants in the international resolution of disputes. Existing DTTs predominantly rely on the mutual agreement procedure (MAP) to resolve tax disputes between competent authorities on a best-efforts basis. The MAP is usually time consuming and requires significant administrative capacity on the part of competent authorities. Such capacity is often lacking, especially in countries with limited resources. In some instances, providing for arbitration between the competent authorities as a prolongation of the MAP can make the procedure more effective because competent authorities have a greater incentive to reach an agreement to avoid escalating the matter to arbitration. However, where the MAP fails due to limited administrative capacity, arbitration will do little to improve the situation. In addition, many developing countries do not have confidence in the arbitration process. The United Nations has tried to address this in its DTT model by providing greater flexibility in implementing outcomes, placing caps on costs, encouraging greater transparency in the proceedings and appointing arbitrators familiar with the situation in developing countries. The key to moving forward is to give a greater voice to developing countries in the design of dispute settlement provisions and to provide for more capacity-building.

Exchange of information

DTTs include exchange of information provisions that require competent authorities (typically the tax authorities of each contracting State) to exchange information where this is relevant to applying the provisions of the DTT or to administering or enforcing the domestic tax laws of either State. Although there is consensus on the importance of these provisions, the administrative aspects of exchange of information continue to be an area of concern, especially in developing countries. The building of technical capacity is a fundamental aspect of reform.

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