The Multilateral Instrument – A Backgrounder
Taxes have been the main source of revenue for kingdoms, empires and countries since time immemorial. Some of the oldest text in the history of governance talk of taxation in some form or the other. Back then taxation was limited to revenues earned within the domain of the ruler; today we call it Domestic taxation. However, after the Industrial dramatical change, trade across borders increased considerably. The various economic theories on international trade rule to countries specializing in producing goods and products in which they had competitive advantage. A country that did not have the competitive advantage in certain goods, clearly imported from a country that had that advantage. And so everyone stood to gain.
But international trade gave rise to various tax issues. These stem mainly from the Source Rule or the Residence Rule of taxation. These rules seem to have been inherited from ancient times in addition.
According to the Source Rule, if a business earns income from a source in a country, that country has the sovereign right to tax the income. The rulers of yore ensured that the caravans that entered their territory from outside, to sell their wares, paid the taxes before they returned. This probably is the genesis of the source rule and maybe customs duty in addition.
Under the Residence Rule, all earnings of tax residents of a country are unprotected to tax in that country. In ancient times, anyone who grew produce in the territory of a ruler, paid a tax on his produce. Somewhere along the way the definition of “all earnings” extended to global earnings and that’s the way it stands today.
At present, the tax laws in most countries, barring a few, follow a combination of the Source Rule and the Residence Rule.
The First Conflict
As international trade increased in the world, the first conflict in taxation surfaced. This was the obvious conflict between the Source Rule and the Residence Rule. This is explained with the help of an example as follows:
Assume a Company A is a tax resident of US and must pay taxes in the USA on its global income under US tax laws. Company A transfers some technology to an Indian Company for use in India. Under Indian tax law, Company A is unprotected to tax in India under the source rule on its earnings from move of technology. And herein lies the conflict. Company A is taxed in India on the move of technology under the source rule and is taxed on the same income in USA under the residence rule, leading to double taxation.
Clearly no prudent business would like to include in cross border trade in such a scenario. Countries stood to lose basic tax revenue as a consequence of this double taxation. It became imperative for the countries to go into intoAgreements for the Avoidance of Double taxation to resolve this issue of double taxation.
Double tax avoidance agreements (DTAA’s)
Countries engaged in International trade consequently began negotiations for the Agreement for Avoidance of Double taxation or DTAA’s as they are often called. The negotiations were mainly bilateral since the economic and trade relations between two countries are specific to those countries. However, to aid in the negotiations and to standardize the formats of the agreements, form DTAA’s and Conventions were developed.
The United Nations developed a UN form Convention with the aim of assisting developing countries in their negotiations with the developed countries. The Organization for Economic Cooperation and Development (OECD), developed its own form Conventionto assist the developed countries. The USA, as a dominant trade partner to most countries, set out her position as a US form. Each of the Models has its own commentaries which explain the provisions of the form. While all the Models contain similar provisions, there are certain important differences. We will discuss these in a later article. The models do not carry the force of law but act as guidance for governments and in the interpretation of DTAAs.
Using these Models as starting points in their bilateral negotiations countries sought to avoid the problem of double taxation by:
- Setting out taxing rights for various kind of income. In the interest of promoting economic development, investments and international trade, some countries agreed to give up their right to tax the income thereby avoiding double taxation
- Setting off the tax paid in one country against the tax payable in the other country. This offset or “tax credit” method that the business is burdened only to the extent of the higher of the taxes in either country.
The DTAAs helped in overcoming the big stumbling block to successful international trade.
But Governments nevertheless lose revenue
The bilateral DTAAs, while principally following the various Models, deviated from them in the language and terms used. These clearly were specific to the negotiations at hand. The end consequence was a plethora of similar DTAA’s but with meaningful deviations in some situations. Large Multinational Companies sought to take advantage of these deviations and engaged teams to look into maximizing the benefits of the “treaty network”. The profession of International Tax Specialists was born. The role of the International tax specialist is to find authentic method of avoiding tax in higher tax territories. They do this inter alia, by locating holding companies in low tax jurisdictions with a popular treaty network resulting in base erosion and profit shifting, commonly referred to as BEPS by the tax authorities.
Governments around the world caught wind of these techniques, also known as “treaty shopping” and sought to prevent this by various anti-avoidance measures. The US tax laws have imposed anti-avoidance measures such as move pricing, controlled foreign corporation rules, thin capitalization rules, and a limitation of assistance clause in its DTAAs. however the loss of revenue continues.
Overtime the way business is done has also changed. The digitization of business processes and e-commerce have resulted in tech companies being able to take advantage of loopholes in the domestic tax provisions of countries, and in the language of the various DTAA’s. It is pertinent to observe that tax provisions and DTAAs are meant to address tax issues relating to the traditional brick and mortar businesses instead of the newer digital commerce. It will take the tax authorities sometime to check the leakage they confront due to digital commerce.
Global Initiatives to check tax leakage
To minimize the negative impact of BEPS, the OECD’s Committee on Fiscal Affairs developed 15 Action Plans and in November 2015 these were endorsed by the OECD Council and leaders of the G20 Countries.
Very briefly, these action plans are as follows:
1. Tax Challenges from digitalization
The action plan seeks to address the challenges and difficulties posed by the digital economy in the application of the existing rules of international taxation.
2. Neutralizing the effect of hybrid mismatch arrangements
Seeks to develop form treaty provisions and general recommendations for domestic rules relating to transparency of entities, dual residency and the application of methods for eliminating double taxation.
3. Controlled Foreign Company rules
General recommendations to strengthen the rules relating to the taxation of Controlled foreign corporations.
4. Limitation of interest deductions
A shared approach based on best practices to prevent base erosion by payment of higher interest in financing intra-group companies.
5. unhealthy tax practices
Mandatory rules to avoid unhealthy tax practices in order to enhance transparency
6. Prevention of treaty abuse
Mandatory provisions and recommendations to prevent treaty abuse. Includes rule purpose test, Limitation of Benefits rule, Dividend move transaction, capital gains tax liability, anti-abuse rule for long-lasting establishments located in third jurisdiction.
7. long-lasting formation position
Recommends changes in the definition of a long-lasting formation to avoid its creation by a Commissionaire structure, specific activity exemption or splitting of contracts.
8. Revision of existing move Pricing standards (covered in Action plans 8 to 10)
Guidance to assure that move pricing outcomes are in line with value creation in intangibles, risks and capital, and other high risk transactions.
9. move Pricing
Same as in Action plan 8
10. move Pricing
Same as in Action Plan 8
11. BEPS Data examination
Methodologies to collect and analyze data on BEPS and action to address the issues arising.
12. Mandatory Disclosure Rules
Design of mandatory disclosure rules for aggressive tax planning.
13. Country-by Country Reporting
Revised guidance on country-by- country reporting to enhance transparency about the Multinational.
14. Mutual Agreement Procedure
Develops solutions to address the obstacles to resolving disputes between tax authorities under the Mutual Agreement Procedure, and includes arbitration as an option for argument resolution.
15. Multilateral Instrument
Provides an examination of the legal issues related to the development of a multilateral instrument to permit the streamlining of the implementation of BEPS issues.
Most of the Action Plans can be implemented by changes made in the domestic tax law of a country. However Action Plan 2 (Neutralizing the effect of hybrid mismatch arrangements), 6 (Prevention of Treaty Abuse), 7 (long-lasting formation position), and 14 (Mutual Agreement Procedure) required a multilateral agreement for implementation. This resulted in the creation of the Multilateral Instrument formally known as “Multilateral Convention to implement tax treaty related measures to prevent Base Erosion and Profit Shifting”.
Disclaimer: This Article is for information only and readers are advised to seek specialized advice before acting upon the information provided herein