Interpretation of tax treaties

Every country has detailed rules of how it tax individuals and entities. Some operate a territorial system where one is taxed based on residence and source, whilst other countries operate a non-territorial method where one is taxed on his worldwide income (e.g. United States of America).?A country’s right to tax income is determined by there being some nexus or link between the country and the income earned. These are known as connecting factors. Connecting factors for residence may include residence, nationality, citizenship, and domicile. Source connecting factors might include location of an asset as well as the concept of “pay” and “use”.

International double taxation

International double taxation occurs when two or more states impose taxes on the same taxpayer for the same income or gains. Most commonly, double taxation arises because states tax not only domestic income or gains but also income and gains in other states which benefit resident taxpayers, resulting in the overlap of the states' tax claims. Double tax treaties (DTTs) address and reduce the extent of this double taxation. The efficacy of the treaty approach, however, depends on common and workable interpretations of the treaty terms. ?

Interpretation of tax treaties

Interpretation of tax treaties is very important. It should be noted that there are no uniform rules that govern interpretation of DTTs, however, one should consider the Organisation for Economic Co-operation and Development (OECD)/United Nations (UN) Model Tax Convention (MTC), The Vienna Convention and a country’s private international law when interpreting a treaty.

The Vienna Convention on the Law of Tax Treaties (VCLT)

The Vienna Convention provides general rules of interpreting tax treaties. It has been accepted in the Commerzbank case law that Article 31- 33 of the Vienna Convention (in addition to other sources) may be used as an aid to interpreting a DTT.

The Article 31 of the Convention provides that a treaty has to be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose. Furthermore, the article provides that in addition to the text of a treaty and its preamble/annexes, the following sources may be referred to when interpreting a DTT:

• Any agreement relating to the DTT which was made between all the parties in connection with the conclusion of a DTT (if there is any).
• Any instrument which was made by one or more parties in connection with a DTT (again, if any).
• Any subsequent agreement between the parties regarding the interpretation of the treaty.
• Any subsequent practice in the application of the DTT.
• Any relevant rules of international law applicable in the relations between the parties.

In addition, Article 32 of the same Convention provides that alternatively reference can be made to supplementary means of interpretation (including the preparatory work of the treaty and the circumstances of its conclusion. However, Article 32 may only be invoked when the application of Article 31 (as discussed above) leaves the meaning ambiguous/obscure or leads to a result which is manifestly absurd or unreasonable. Therefore, the scope of Article 32 is somewhat limited but may nevertheless be helpful in interpreting/finding the purposive meaning of a provision of a DTT.

Article 33 also provides some guidance as to interpretation of treaties authenticated in two or more languages.

Definitions not provided in the treaty

Most tax treaties follow the OECD MTC including the ones signed by Zambia. Article 3(2) of the OECD MTC provides that any term not defined in the convention shall (unless the context otherwise requires) have the meaning that it has under the applicable domestic laws. However, the meaning of the term should be interpreted in accordance of the principles of Article 31 of the VCLT, that is, the term should be interpreted in good faith taking into consideration the objects and purpose of the DTT.

An amendment to the OECD/UN MTC Commentary

Commentary may be referred to when interpreting the meaning of a particular provision of the DTT in question. Accordingly, an amendment to the OECD Commentary may then be taken into account when interpreting the treaty. There are two approaches to interpreting the treaty, namely, static approach and ambulatory approach.

Static approach means that the DTT in question may only be interpreted by reference to OECD Commentary that was published on or before the date the DTT was signed. On the other hand ambulatory approach would consider later amendments to the commentary after the treaty date. For example, the UK (largely) follows ambulatory approach.

In the Smallwoods case the court held that, “it would be unwise to shut one’s eyes to developments in the international tax arena”. It was concluded that it is important to consider the purpose of the treaty and the relevant Commentary and then consider if the Commentary can apply.

Addition of Article 27 – Assistance in collection of taxes

Article 27 was introduced in the MTC in 2002 and it mandates countries with a treaty to assist each other in the collection of taxes. It is no doubt that all treaties signed between different countries before 2002 had no inclusion of Article 27. Countries may choose to or not to adopt this article in their treaties. For example, Zambia updated its tax treaty with Netherlands and included the provisions of this Article in the treaty which came into effect on 1 January 2019. However, where a country choose to adopt this article into the existing DTT, the popular question is whether the application of Article 27 will have a retrospect effect. Unfortunately yes.

The OECD commentary at paragraph 14 states that nothing prevents the article being applied to claims that arise before the convention comes into force, unless a specific clause to that effect has been inserted in the DTT.

There are two recent tax cases where this approach has been taken by judges. In Ben Nevis Holdings UK, the article was used to help the South African Revenue Service (SARS) collect a debt in relation to a BVI company, where the debt arose from 1998-2000 and the article was only introduced into the treaty from 2008. The funds were in a London bank account, so foreign court requested the United Kingdom (UK) to assist with the collection. The UK court decided the UK could assist in the collection, because the historical nature of the debt was not relevant to the article, so they froze the London bank account of the company, and then permitted SARS to collect the debt once the case was settled. A very similar fact pattern existed in the more recent Kook v SARS case where again Article 27 was introduced into the relevant tax treaty after the debt arose, but the supreme court of South Africa still ruled it could be used to collect the historical debt.

Relevance of case laws

Court decisions may be referred to when interpreting a provision of a DTT, but such decisions will only have persuasive value. It is worth noting that UK courts frequently refer to foreign judgments (especially common law judgments).

Conclusion

Tax treaty interpretation has significant consequences for the taxation of cross border transactions. Only a uniform interpretation among states will ensure an efficient and equitable application of tax treaties, which aim to eliminate double taxation and also prevent tax evasion.

Zambia currently has DTTs with Botswana, Canada, China, Denmark, Finland, France, Germany, India, Ireland, Italy, Japan, Kenya, Netherlands, Norway, Romania, South Africa, Sweden, Tanzania, Uganda and the United Kingdom among others.

NB: THIS ARTICLE WAS PREVIOUSLY PUBLISHED BY HLB ZAMBIA IN ITS NOVEMBER 2021 ISSUE OF THE MONTHLY TAX FLASH.