Taxing Service Payments and Royalties under the OECD and UN Model Tax Conventions

In the Transfer Pricing Database published by CIAT there is a section titled ‘Aspects Related to the BEPS Project’ in which the tax administrations of 15 Latin American countries list the transactions that most erode their tax base.[1] Nine of these countries (60%) specifically mention base erosion due to royalty payments and service fees. This predicament is a common characteristic in developing countries around the world. The root of the problem stems from the fact that Article 12(1) of the Organization for Economic Cooperation and Development (OECD) Model Tax Convention reads as follows:

Art. 12 (1) “Royalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in that other state.” – OECD Model Tax Convention, 2017.

This means that exclusive taxation rights are given to the country where the owner of the royalties is resident (unless there is a permanent establishment to which the royalties can be attributed, in the state where they arise). Usually, the owner of the royalties is located in a developed country where sufficient financial resources and technological infrastructure is available for research and development teams to create the subject of the royalties. In effect, this makes the developing countries the ones who are most often stripped of their taxing rights.

In this case, the exclusive attribution of taxing rights makes it unnecessary to define the term ‘arising in’. Furthermore, the reference to ‘beneficial ownership’ takes on a different meaning than that of the Financial Action Task Force (FATF) recommendations. For this article, as well as Articles 10 (dividends) and 11 (interest), the beneficial owner is the party who has the unconstrained right to use and enjoy the dividends, interest or royalties.[2] This general definition could allow for royalties to be allocated to the jurisdiction where the company headquarters is located (given that the headquarters are responsible for deciding what to do with the payments the company receives).

In this context, Article 12 and the newly added Article 12A of the 2017 United Nations (UN) Model Double Taxation Convention may prove more appropriate for developing countries. An alteration to Article 12 paragraph (1) improves the level of equality between countries, this reads as follows:

Art. 12 (1) “Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.” – UN Model Tax Convention, 2017.

This gives us a shared attribution: primary taxing rights are in the state of residence and secondary taxing rights in the state where the royalties arise. Therefore, it is necessary for Article 12 (5) of the UN model to provide us with further certainty by defining the term ‘arising in’;

Art. 12 (5) “Royalties shall be deemed to arise in a Contracting State when the payer is a resident of that State. Where, however, the person paying the royalties, whether he is a resident of a Contracting State or not, has in a Contracting State a permanent establishment or a fixed base in connection with which the liability to pay the royalties was incurred, and such royalties are borne by such permanent establishment or fixed base, then such royalties shall be deemed to arise in the State in which the permanent establishment or fixed base is situated.” – UN Model Tax Convention, 2017.

Essentially, this article provides more opportunities and justification for developing countries to impose their taxing rights. However, there is still a conundrum to be solved as many times it is hard to distinguish between payments for royalties and payments for technical, managerial or consultancy services. Service payments are not covered under the definition of royalties in either the OECD or the UN Models. Furthermore, services are often provided through digital means, without physical presence in the state of source, this causes confusion and tax disputes as to the registration of the income.

Therefore, a supplementary provision; Article 12A was added to the UN Model in 2017 to explicitly cover these payments. This article is not yet present in many double tax treaties given its young life span and the ubiquitous prevalence of using the OECD Model, however, for countries that have a significant amount of outbound royalty and service payments it may be desirable to renegotiate relevant treaties to include this provision. The article reads as follows:

Art. 12A (1) “Fees for technical services arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.” – UN Model Tax Convention, 2017

Following the precedent set out in the previous article, 12A gives primary taxing rights to the state where the service was provided (where the fees arose) and secondary rights  to the state of residence. Distinctive to other articles, the imposition of tax does not require a physical nexus like a fixed base or a permanent establishment, bestowing a potential solution for evasion relating to the digital service economy.

Lastly, if renegotiation of the existing treaties is not feasible, one tool for reducing the abuse associated with royalties, dividends and interest, is to simply check whether the entity (to whom the payment is being made) meets the definition of ‘beneficial owner’ as required by the treaty. If the definition is not found in the treaty, it may be attained through;

  • i. a reference to the UN or OECD model commentaries,
  • ii. a reference to the domestic tax law definition via the employment of Article 3 paragraph (2) (if available),[3] or
  • iii. via Article 25 paragraph (3) found in both the OECD and UN models which provides for the mutual agreement procedure to be used in situations where doubts arise as to the interpretation or application of the treaty.

This analysis of the various Article 12 provisions in the OECD and UN models, should allow developing countries to make an informed decision about which text fits best for their situation.

[1] Found at CIATData: https://ciatorg.sharepoint.com/:x:/s/cds/EfUl0OKEdK9Dv97SROi_AYcBjBQganLHaETDJLx4Ql1wGg?rtime=4M2g6cfT1kg

[2] OECD, 2017 Model Tax Convention, Commentary of Article 12 paragraphs 4-4.3.

[3] In the OECD and UN Models, Article 3(2) reads: 3.(2) As regards the application of the Convention at any time by a Contracting State, any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of that State for the purposes of the taxes to which the Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State.

Disclaimer. Readers are informed that the views, thoughts, and opinions expressed in the text belong solely to the author, and not necessarily to the author's employer, organization, committee or other group the author might be associated with, nor to the Executive Secretariat of CIAT. The author is also responsible for the precision and accuracy of data and sources.

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