STIESA/94

MANUAL FOR THE NEGOTIATIONOF BILATERAL TAX TREATIES

BETWEEN DEVELOPEDAND DEVELOPING COUNTRIES

UNITED NATIONS

ST/ESA/94

Department of International Economic and Social Affairs

MANUAL FOR THE NEGOTIATIONOF BILATERAL TAX TREATIES

BETWEEN DEVELOPEDAND DEVELOPING COUNTRIES

UNITED NATIONSNew York, 1979

NOTE

Symbols of United Nations documents are composed of capital let-ters combined with figures. Mention of such a symbol indicates a referenceto a United Nations document.

The designations employed and the presentation of the material inthis document do not imply the expression of any opinion whatsoever onthe part of the Secretariat of the United Nations concerning the legalstatus of any country or territory or of its authorities, or concerning thedelimitation of its frontiers.

ST/ESA/94

UNITED NATIONS PUBLICATION

Sales No. E.79.XVI.3

Price: $U.S. 10.00(or equivalent in other currencies)

CONTENTS

PageINTRODUCTION ........................................ 1

Part One

Analytical and historical review of internationaldouble taxation and tax evasion and avoidance

Chapter

I. INTERNATIONAL DOUBLE TAXATION .................... 11A. Concepts and issues ................. .......... 11B. Historical overview ............................. 16

II. INTERNATIONAL TAX EVASION AND AVOIDANCE ............ 22A. Concepts and issues ............................ 22B. Historical overview ............................. 29

Part two

Guidelines for the formulation of the provisions of abilateral tax treaty between a developing country

and a developed country

PREFACE TO THE GUIDELINES ............................. 35SUMMARY OF THE GUIDELINES ............................ 39

Part Three

Suggestions relating to the application of the guidelinesand to procedural aspects of tax treaty negotiations

I. PROCEDURAL ASPECTS OF MUTUAL AGREEMENT PROCEDUREPROVIDED FOR IN GUIDELINE 25 ..................... 105

A. General considerations .......................... 105B. Information on adjustments ..................... 105C. Invocation of competent authority consultation at point

of proposed or concluded adjustments .............. 106D. Correlative adjustments ......................... 107E. Publication of competent authority procedures and

determ inations ................................ 110F. Procedures to implement adjustments .............. 110G. Unilateral procedures .......................... 111

iii

Chapter Page

II. SUGGESTIONS FOR THE ALLOCATION OF RECEIPTS AND EX-

PENSES CONCERNING PAYMENTS FOR GOODS, TECHNOLOGY

AND SERVICES IN RELATION TO TRANSACTIONS BETWEEN RE-

LATED ENTITIES .................................. 112

A. Allocation of receipts and expenses concerning the saleof goods (or tangible assets) ..................... .113

B. Allocation of receipts from the use of patent rights .... 121C. Allocation of receipts from the provision of services . .. 131

III. SUGGESTED ARRANGEMENTS BETWEEN TREATY COMPETENT

AUTHORITIES REGARDING EXCHANGE OF INFORMATION ..... .146

A. Routine transmittal of information ................ 146B. Transmittal on specific request .................... 149C. Transmittal of information on discretionary initiative of

transmitting country ......................... 151D. Use of information received ............... .... 151E. Consultation among several competent authorities .... 152F. Over-all factors ............................... 152

IV. PROCEDURAL ASPECTS OF TAX TREATY NEGOTIATIONS ...... 156

A. Identification of the need for a treaty .............. 156B. Initial contacts .......................... ..... 156C. Appointment of a delegation .................... 156D. Preparations for negotiations .................. .157E. Arrangements for meetings between negotiating delega-

tions ....................................... 157F. Conduct of the negotiations ...................... 158G. Preparations for the signature of the treaty ......... 159H. Miscellaneous considerations .................... 159

ANNEX

MODEL CONVENTIONS AND DRAFT MODEL CONVENTIONS FOR THEAVOIDANCE OF DOUBLE TAXATION ...................... 161

iv

INTRODUCTION

The question of the costs and benefits of foreign investment has formany years been the subject of intense discussion within the United Na-tions system of organizations and in other international forums. It is rec-ognized that these costs, if not given due consideration in investmentdecisions, can outweigh the benefits to be derived from the investmentconcerned. Foreign investment generates profits which, if not reinvestedin the host country, need to be transferred elsewhere; it also entails royaltypayments, fees for managerial and technical services and other paymentsof a similar nature which have to be remitted abroad. Such financial trans-fers may exert great pressure on the balance-of-payments position of de-veloping countries. On the other hand, it is also recognized that foreigninvestment, properly integrated into the political, economic and socialpriorities of developing countries, can make a positive contribution totheir economic and social development.

The desirability of promoting greater inflows of foreign investmentto developing countries under conditions that are politically acceptableas well as economically and socially beneficial has been frequently af-firmed in resolutions of the General Assembly, the Economic and SocialCouncil and the United Nations Conference on Trade and Development.The countries participating in the Paris Conference on InternationalEconomic Co-operation recognized that foreign private capital flows andinvestment play an important complementary role in the economic de-velopment process, particularly through the transfer of resources, mana-gerial and administrative expertise and technology to the developingcountries, the expansion of productive capacity and employment in thosecountries and the establishment of export markets.

The growth of investment flows from developed to developing coun-tries depends to a large extent on what has been referred to as the inter-national investment climate. The prevention or elimination of internationaldouble taxation - the latter being the imposition of similar taxes in twoor more States on the same taxpayer in respect of the same base - con-stitutes a significant component of such a climate. As the Fiscal Commit-tee of the Organization for Economic Co-operation and Development(OECD) observed, "apart from the solution of concrete tax problemsrelating to international trade and investment, tax conventions [for theprevention or elimination of double taxation] can provide an improve-ment in the general tax atmosphere by offering re-assurance to investorsand businessmen that there exists a mechanism for the settlement of taxgrievances that may arise. The mere fact of a tax treaty having beenagreed to, even if it provides no formal procedures for the settlement ofdifferences, conveys a sense of co-operation between the authorities ofthe two countries which instills confidence that potential disputes can besettled on reasonable terms. In addition, however, tax treaties may pro-

1

vide authorisation for specific procedures, for mutual agreement in thesettlement of differences".'

The conclusion of bilateral tax treaties for the prevention or elimi-nation of double taxation has emerged since the 1960s as a salient featureof inter-State economic relations. Of the approximately 400 bilateral taxconventions for the avoidance of double taxation with respect to taxeson income and capital currently in force, about half have been concludedbetween the member countries of OECD, while the other half have beenconcluded between those countries and the developing countries. Sincethere are about 120 of the latter, it can be seen that, considering the num-ber of bilateral tax treaties that could be entered into as a result of variouscombinations of developed and developing countries, the number ofsuch treaties currently in force is comparatively small. Many developingcountries have yet to enter into bilateral tax treaties with developedcountries and even those which have entered into such treaties have yetto do so on a scale commensurate with their foreign capital requirements.It may be noted incidentally that a small number of such treaties havebeen concluded between developing countries and this trend may beexpected to continue in the light of the prospects for increasing co-operation among developing countries.

Although, as noted above, only a comparatively small number oftreaties have been concluded between developed and developing coun-tries, many of the latter countries alleviate the effective tax burden onforeign investors by unilaterally offering them major tax incentives whichmay include income tax exemptions or a low tax rate on all or certaincorporate profits, extra-deductions for business expenses aimed at secur-ing export sales or deduction of some fraction of export proceeds oroutright exemption of profits on export sales, reduction of withholdingtaxes on dividends and interest, reductions on individual income taxesfor expatriate personnel, exemption from import duties and accelerateddepreciation or percentage depletion allowances for mining resources.These incentives may yield benefits far exceeding those that can be de-rived from bilateral tax treaties. It is also true that the domestic legisla-tion of several developed countries provides unilateral relief from doubletaxation.

However, unilateral tax credit relief by the investor's country maynot always help developing countries to achieve their aim of providingthe foreign investor with tax benefits. In effect, when the tax credit pro-visions of a developed country entail only a reduction in that country'stax equal to the foreign tax actually paid, any relief given by a developingcountry with regard to profits currently taxed in a developed countrywill be reflected in an increase in the developed country's tax. In the end,it is as though the treasury of the developing country transferred theamount of the tax it has forgone to the treasury of the developed country.The foreign investor pays the same amount of tax, but pays more to thedeveloped country and less to' the developing country. Moreover, in thecase of profits not currently taxed in a developed country, the grantingof tax holidays may encourage the allocation of profits to entities benefit-

' Organization for Economic Co-operation and Development, Fiscal Incentivesfor Private Investment in Developing Countries: Report of the Fiscal Committee(Paris, 1965), para. 166.

2

ing from such holidays in the absence of effective provisions in a treatywhich would help to prevent deviation from proper arm's-length dealingsand correct cost allocation.

Theoretically the unilateral approach to the elimination of doubletaxation should involve no difficulty at the international level, since thedecision to apply it depends on one State only. Nevertheless, it involvesunilateral sacrifices by that State. Moreover, experience has shown thatthe unilateral approach to the provision of relief may not by itself befully adequate to eliminate or alleviate the effects of double taxation.This inadequacy stems from the diversity of tax systems which, in turn,originates from differences in legal and tax history, fiscal policy, revenueneeds and the level of compliance and enforcement. These differences arereflected in the approach that a country takes to the promotion of foreigninvestment, the characterization and computation of taxable income andthe various methods of allocating income to domestic and foreign sources.Statutory tax rates are not meaningful as such and are comparable onlyif the base to which they are applied, that is, the determination of incomesubject to the tax, is taken into account. As a result of the growing com-plexity of tax systems and the multiplicity of taxes levied, it has becomeincreasingly difficult to provide fully effective relief from internationaldouble taxation through the unilateral approach, which in practice doesnot always work perfectly.

The Fiscal Committee of OECD acknowledged as early as 1965that "the traditional tax conventions have not commended themselves todeveloping countries". 2 According to that Committee, "the essential factremains that tax conventions which capital-exporting countries havefound to be of value to improve trade and investment among themselvesand which might contribute in like ways to closer economic relationsbetween developing and capital-exporting countries are not making suffi-cient contributions to that end . . . Existing treaties between industrializedcountries sometimes require the country or residence to give up revenue.More often, however, it is the country of source which gives up revenue.Such a pattern may not be equally appropriate in treaties between de-veloping and industrialized countries because income flows are largelyfrom developing to industrialized countries and the revenue sacrificewould be one-sided. But there are many provisions in existing tax con-ventions that have a valid place in conventions between capital-exportingand developing countries too".3

Bilateral tax treaties can solve many of the double taxation problemsby reconciling the differences in the concepts of various types of incomeand their geographical source, establishing a common method of deter-mining how certain items of income shall be classified and taxed, and eitherassigning exclusive tax jurisdiction over certain items of income to one ofthe treaty countries or dividing the tax revenue between the two countrieswhen neither is willing to relinquish its claim entirely. Furthermore, inmany cases capital-exporting countries have granted relief under bilateraltreaties in forms that they are not prepared to extend indiscriminately bystatute. For example, some capital-exporting countries whose internal

2 Ibid., para. 164.3 Ibid., paras. 163 and 165.

3

legislation provides no significant relief from double taxation or providesrelief essentially through the credit method have agreed under bilateraltreaties to exempt from taxation income generated in the other treatycountries or to tax such income at a reduced rate. Conversely, capital-importing countries may grant considerably more far-reaching relief un-der a treaty than that which is available to investors residing in non-treatycountries. Tax treaties thus permit a degree of mutual accommodationwhich is not possible under the much less flexible statutory schemes thatapply to transactions with all countries in general. Additional benefits ofsuch treaties, and of the orderly international tax relationships createdby them, are the exchange of fiscal information and procedures for mu-tual assistance among the contracting States and the customary non-discriminatory clause of the treaties, which puts local businesses ownedby foreign investors on an equal footing with local businesses owned bylocal investors.

Experience shows that bilateral tax treaties have been negotiated inthe light of various monetary, fiscal, social and other policies important tothe negotiating parties. Furthermore, their conclusion between developedcountries has been facilitated by the fact that the parties have tradition-ally been at approximately similar levels of development, so that thereciprocal flows of trade and investment - and hence the respective gainand loss of revenue to the parties - have been relatively equal in mag-nitude. However, the presumption of equal reciprocal advantages andsacrifices underlying treaties between developed countries is not equallyvalid when the negotiating or contracting States are at vastly differentstages of economic development. A loss of revenue which may be ofrelatively minor importance to a developed country can constitute aheavy sacrifice for a developing country. For many developing countries,the scarcity of foreign exchange resulting from the outflow of tax-exemptlocally produced income may be of even greater importance than the lossof revenue. Consequently, developing countries have, generally speaking,been reluctant to enter into tax treaties under which, according to them,their tax revenue from locally produced income and their foreign exchangereserves might be reduced unless they can reasonably assume that thetreaties will ensure that the risk of tax revenue and foreign exchange losseswill be offset by advantages flowing from provisions on such matters asexchange of information with a view to eliminating tax evasion, and tax-sparing or other tax incentives in the capital-exporting countries thatmay be expected to increase flows of capital and technology into thedeveloping countries.

With a view to promoting the conclusion of bilateral tax treatiesbetween developed and developing countries which would be beneficialto both parties, the United Nations deemed it desirable to follow in thefootsteps of the League of Nations. The United Nations efforts to thatend originated in Economic and Social Council resolution 1273 (XLIII)of 4 August 1967, which requested the Secretary-General "to set upan ad hoc working group consisting of experts and tax administratorsnominated by Governments, but acting in their personal capacity, bothfrom developed and developing countries and adequately representingdifferent regions and tax systems, with the task of exploring, in con-sultation with interested international agencies, ways and means for facil-

4

itating the conclusion of tax treaties between developed and developingcountries, including the formulation, as appropriate, of possible guide-lines and techniques for use in such tax treaties which would be acceptableto both groups of countries and would fully safeguard their respectiverevenue interests".

Pursuant to that resolution, the Secretary-General set up in 1968the Ad Hoc Group of Experts on Tax Treaties between Developed andDeveloping Countries, composed of tax officials and experts from thefollowing countries, appointed in their personal capacity: Argentina,Chile, France, Germany, Federal Republic of, Ghana, India, Israel,Japan, the Netherlands, Norway, Pakistan, the Philippines, the Sudan,Switzerland, Tunisia, Turkey, the United Kingdom of Great Britain andNorthern Ireland and the United States of America. At the request ofthe Economic and Social Council, the Secretary-General increased thenumber of members of the Group of Experts by adding an expert fromSri Lanka in 1972 and an expert from Brazil in 1973.

The Group of Experts has held seven meetings, which were attendedby observers from Austria, Finland, Mexico, Nigeria, the Republic ofKorea, Swaziland and Venezuela and from the following internationalorganizations: the International Monetary Fund, the International FiscalAssociation, the Organization for Economic Co-operation and Develop-ment, the Organization of American States and the International Chamberof Commerce.

In the course of its discussions, the Group of Experts has formulatedguidelines on issues arising in connexion with the negotiation of bilateraltax treaties. According to Economic and Social Council resolution 1541(XLIX), the guidelines should represent "an important form of technicalassistance for the conclusion of future treaties". At its Seventh Meeting,the Group of Experts was of the view that, if the guidelines were to fulfilthat function effectively, they must be consolidated and issued in a singledocument which should be widely disseminated. The Group thereforerequested the Secretariat to prepare a draft consolidated document andentrusted the Drafting Committee set up at its Seventh Meeting with theresponsibility for reviewing the Secretariat's draft to ensure that theguidelines accurately reflected the Group's positions.

The Secretary-General, in his report to the Economic and SocialCouncil at its first regular session, 1978 (E/1978/36), indicated thatwhile concurring with the suggestion of the Group of Experts, he alsoconsidered that there was a need to familiarize tax officials in developingcountries with the basic approaches and methods used in the field ofinternational taxation and that it would therefore be desirable for theconsolidated guidelines to be supplemented by explanations of those basicapproaches and methods, the whole to be embodied in a special pub-lication which could be entitled "Manual for the negotiation of tax treatiesbetween developed and developing countries".

The suggestion concerning the preparation of the Manual was ap-proved by the Economic and Social Council in decision 1978/14. Inorder to benefit from the technical expertise of the members of the Draft-ing Committee, the Secretary-General decided to invite the DraftingCommittee not only to examine on behalf of the Group the sections of

5

the Manual dealing with the guidelines and the summaries of the discus-sion of the Group of Experts so as to ensure their consistency with theGroup's positions, but also to review the other sections of the Manualfrom the technical standpoint.

The Manual consists of three parts: Part One contains an analyticaland historical review of international double taxation and tax evasion andavoidance. Part Two contains in consolidated form the guidelines for-mulated by the Group of Experts. Part Three contains suggestions relatingto procedural aspects of tax treaty negotiations and to the application ofthe guidelines. The Annex to the Manual reproduces the texts of theModel Bilateral Convention for the Prevention of the Double Taxationof Income, the Model Bilateral Convention for the Prevention of theDouble Taxation of Income and Property, the Model Convention for theAvoidance of Double Taxation Between Member Countries and OtherCountries Outside the Andean Subregion, and the OECD Model DoubleTaxation Convention on Income and on Capital and the Conventionon Administrative Assistance in Tax Matters concluded by Denmark,Finland, Iceland, Norway and Sweden.

In drafting the Manual the Fiscal and Financial Branch of theDepartment of International Economic and Social Affairs of the UnitedNations Secretariat drew upon, inter alia, technical reports prepared underthe auspices of the League of Nations, reports of the Fiscal Committeeof OECD and its successor, the Committee on Fiscal Affairs, and variousworking papers submitted to the Group of Experts by its members.*In Part Two, the observations on each guideline summarize the relevantdiscussions in the Group of Experts.5

In preparing the Manual, the Fiscal and Financial Branch of the

4 These papers include:"Suggested guidelines-payment for goods, technology, services", contributed

by Mr. M. H. Collins, Assistant Secretary, Board of Inland Revenue of the UnitedKingdom;

"Procedural aspects of tax treaty negotiations", contributed by Mr. MordecaiS. Feinberg, Associate Director, Office of International Tax Affairs, United States;

"Proposed guidelines for the taxation of capital gains", contributed by Mr.Mordecai S. Feinberg;

"Proposals concerning the preparatory work for a multilateral agreement onthe exchange of information on direct taxation", contributed by Mr. S. Gafni,former Director of State Revenue, Israel;

"Tax fraud and international co-operation: France", contributed by Mr. PierreKerlan, Directeur Adjoint, Direction g6n6ral des imp6ts, France;

"Interest on deferred credits: taxation of interest on credit sales", contributedby Mr. Pierre Kerlan;

"Taxation of non-permanent residents", contributed by Mr. Pierre Kerlan;"Proposed guidelines for exchange of information for the prevention of re-

course to tax havens", contributed by Mr. S. Narayan, Former Chairman of theCentral Board of Direct Taxes, India;

"Proposed guidelines for allocation of income from the sale of goods, the useof patent rights and the provision of services", contributed by Mr. N. M. Qureshi,Chairman of the Central Board of Revenue, Pakistan; and

"Tax avoidance and tax evasion in India", contributed by Mr. R. D. Shah,former Chairman, Central Board of Direct Taxes, India.

5 A complete summary of the discussions of the Group of Experts is containedin the reports of the Group on its various meetings (see United Nations publications,Sales Nos. E.69.XVI.2; E.71.XVI.2; E.72.XVI.4; E.73.XVI.1; E.75.XVI.1;E.76.XVI.3; and E.78.XVI.1).

6

Department of International Economic and Social Affairs of the UnitedNations Secretariat benefited from the valuable information gathered byMr. Mitchell B. Carroll, President of the Fiscal Committee of the Leagueof Nations from 1938 to 1946 and currently Honorary President of theInternational Fiscal Association. The Branch also benefited from thecomments and suggestions of Professor Stanley Surrey of Harvard Uni-versity (United States of America), of Mr. Olav Snellingen, AssistantGeneral Counsel (Taxation), International Monetary Fund, of individualmembers of the Group and of observers attending the Group's meetings.

The Manual was submitted to the Drafting Committee which metat United Nations Headquarters from 22 to 26 January 1979. At itsopening meeting, the Drafting Committee was addressed by Mr. P. N.Dhar, Assistant-Secretary-General for Research and Analysis, Depart-ment of International Economic and Social Affairs of the United NationsSecretariat. Mr. Dhar observed, inter alia, that the work of the DraftingCommittee, which would constitute the culmination of 10 years of inten-sive examination by the Group of Experts of the complex issues relatingto double taxation, would form part of the broader efforts being made bythe international community to work out an international framework ofco-operation conducive to equitable development.

The Drafting Committee was composed as follows: Mr. V. V.Badami (India); Mr. Maurice Hugh Collins (United Kingdom of GreatBritain and Northern Ireland) accompanied by Mr. B. D. Kent; Mr.Francisco 0. N. Dornelles (Brazil); Mr. 'Pierre Kerlan (France) accom-panied by Mr. Jean-Frangois Court; Mr. Max Widmer (Switzerland);and Mr. J. Pierre V. Benoit, Head, Fiscal and Financial Branch, De-partment of International Economic and Social Affairs, United NationsSecretariat.

The Meeting of the Drafting Committee was also attended by othermembers of the Group and observers. The former were: Mr. MordecaiFeinberg (United States of America); Mr. H. Krabbe (Federal Republicof Germany); Mr. E. Plana (Philippines); and Mr. A. Scheel (Norway).

The observers were: Mr. C. S. Ahn (Republic of Korea); Mr. J. H.Christianse (International Fiscal Association) accompanied by Mr. S. I.Roberts and Mrs. Tony Robinson; Mr. F. Garcia (Venezuela); Mr. J.Gilmer (Organization for Economic Co-operation and Development);Mrs. Helena Ikonen (Finland) and Mr. Olav Snellingen (InternationalMonetary Fund).

Mr. Mitchell Carroll attended the Meeting of the Drafting Com-mittee as a Special Guest.

Mr. J. Pierre V. Benoit served as Chairman of the Drafting Com-mittee; Mr. Jean Causse, Senior Economic Affairs Officer in the Fiscaland Financial Branch, and Mr. Karol Krcmery, Chief of the Inter-national Tax Section of the Fiscal and Financial Branch, served as Co-secretaries of the Committee; and Mr. Andrew Ezenkwele, EconomicAffairs Officer in the Fiscal and Financial Branch, served as DeputySecretary.

Professor Stanley Surrey acted as Special Adviser to the DraftingCommittee.

7

Part One

ANALYTICAL AND HISTORICAL REVIEW OFINTERNATIONAL DOUBLE TAXATION AND

TAX EVASION AND AVOIDANCE

I. INTERNATIONAL DOUBLE TAXATION

A. CONCEPTS AND ISSUES

1. The jurisdictional basis of international taxation:the source, residence and nationality principles

Two main principles underlie the jurisdictional basis of taxation:the source or situs principle and the residence or fiscal domicile principle.Under the source principle, a State taxes all income earned from sourceswithin its territorial jurisdiction. Under the residence principle, on theother hand, a State taxes the world-wide income of persons residingwithin its territorial jurisdiction.

All States tax on the basis of the source principle, but some coun-tries, including Argentina, the Dominican Republic, Haiti, Panama andVenezuela tax on the basis of that principle alone. On the one hand, it isoften argued that taxation only on the basis of the source principle ac-tually encourages nationals or residents of the country concerned toinvest abroad, thus leading to the flight of capital needed for domesticinvestment. On the other hand, it is frequently observed that countriesusing only the source principle have adopted it out of necessity becauseof the great difficulties their tax administrators would encounter if theyattempted to find out how much foreign-source income was accruing totheir residents. It is hoped that tax treaties may help to remedy the lattersituation to some degree if they contain appropriate exchange-of-information provisions; this situation could also be remedied if a multi-lateral agreement on exchange of information for tax purposes couldbe concluded.

The great majority of countries have tax systems which combineboth the source principle and the residence principle with some countries,mainly developing ones, relying only on the former. The residence prin-ciple, although based on over-all capacity to pay, has proved to be ofonly very limited revenue significance in a country whose residents do nothave substantial investments in other countries and whose fiscal adminis-tration is not well equipped to ensure its application.

There is also a third principle, that of nationality, which is appliedby only a few countries including Mexico, the Philippines and the UnitedStates of America whose tax systems combine that principle with thesource and residence principles. In the United States, for example, underthe nationality principle, citizens, wherever resident, are taxed on theirworld-wide income. The United States likewise taxes aliens residentwithin its territory on their world-wide income and also taxes incomederived by non-resident aliens from sources within its territorial jurisdic-tion. In that country, domestic trusts and estates have the same tax statusas United States citizens and residents, while the status of foreign trustsand estates is the same as that of non-resident aliens. Corporations incor-

11

porated in the United States, irrespective of the location of their headoffices or seats or places of management and control, are taxed on theirworld-wide income, while foreign corporations are generally taxed solelyon income derived from United States sources or on income which iseffectively connected with a business which a foreign corporation carrieson in the United States.

2. The concept of international double taxation

The current application of tax systems based in varying degrees onthe source, residence and nationality principles inevitably gives rise tooverlapping assertions of tax jurisdiction, resulting in what is generallyknown as international double taxation. At a seminar held during theThirty-first Congress of the International Fiscal Association, interna-tional double taxation was defined as "the result of overlapping tax claimsof two or more States". The following reasons were given for this cumu-lation of taxes:

"1. Two States may tax a person (individual or company) onhis world-wide income or capital because of his personal link withthe States (domicile, residence, nationality, place of incorporationor management): so-called concurrent full liability to tax;

"2. One State taxes a person on his world-wide income orcapital, because he is resident (fully liable to tax) there, and theother State taxes the same person on income he derives from thatState or on capital situated therein (so-called limited liability totax); that is, the conflict of residence against source or situs;

"3. A person is subjected to limited liability to tax in twoStates; main example: an enterprise of State A having a permanentestablishment in State B which derives income from State C: case ofconcurrent limited liability to tax in States B and C."1

The consequences of international double taxation are generallyadverse, not only as regards the taxpayer involved but also as regards theinternational flow of private capital. It may result in an inequitable dis-tribution of the tax burden, according to whether taxpayers invest abroador not. At prevailing income tax rates, taxation of the same income bytwo States may constitute a prohibitive burden on the taxpayer, leadingto a decline in foreign involvement. Alternatively, lack of co-ordinationmay result in unintended tax benefits in respect of income from suchinvestments. In either case, the outcome is a tax-induced distortion of theallocation of capital among countries, with a probable loss of efficiencyin the world-wide use of capital.

3. Methods for the provisions of relief from internationaldouble taxation

Two main methods have commonly been used to prevent inter-national double taxation, whether on a unilateral basis or within the

1 International Fiscal Association, The Revised OECD Model Double Taxa-tion Convention on Income and Capital: Proceedings of a Seminar held in Viennain 1977 during the Thirty-first Congress of the International Fiscal Association,Introduction by Dr. M. Widmer, p. 9.

12

framework of bilateral tax treaties, namely the exemption method andthe credit method.

(a) The exemption method(i) Exemption as a unilateral relief methodUnder the exemption method, the investor's country of residence

exempts from taxation certain items of income from foreign sources.In other words, that country grants the country where the income isgenerated - the source country - the exclusive right to tax that item ofincome. The country of residence may take into account that income indetermining the progressive rate of tax applicable to the taxable income(exemption with progression). As a rule, such exemptions are confinedby statute to profits of foreign permanent establishments and incomefrom real estate situated abroad. The full exemption of foreign-sourceincome from taxation by the country of residence may place the investorin a position of tax equality with residents of the source country, becausethe tax on that income is determined solely by the level of taxation in thelatter country. Thus, tax concessions granted by the source country arenot reduced or cancelled by the tax of the investor's country of residence.Countries using the exemption method normally do not exempt dividends,interest and royalties from foreign sources from the domestic income tax.Many developed countries, however, grant special relief for domesticintercorporate dividends in order to eliminate or mitigate recurrent cor-poration taxation, first at the level of a subsidiary and then again at thelevel of the parent company. Some of these countries, either by internallaw or by treaty, extend this exemption even to dividends paid by aforeign subsidiary to a domestic parent.

(ii) Exemption as a bilateral relief methodWhen the exemption method is applied within the framework of a

bilateral tax treaty, one of the Contracting States is granted the exclusiveright to tax certain items of income. As in the case of unilateral exemp-tion, the exemption by one Contracting State of all or part of an item ofincome may be integral or may occur with progression. In the case of fullexemption, a country of residence may be forbidden to take the exempteditem into account in computing its residents' taxable income. In the caseof exemption with progression, the country of residence reserves theright to take the exempted income into account in determining the tax rateto be applied to the balance of the income, so that the tax on the lattermay in practice constitute a partial tax on the otherwise exempted income.The exemption with progression method has been used in treaties con-cluded by Austria, Belgium, the Federal Republic of Germany, Finland,France, Iceland, Luxembourg, the Netherlands, Spain and Switzerland.

(b) The credit method

(i) Tax credit as a unilateral relief methodThe essential feature of the credit method is that the investor's

country of residence treats the foreign tax, within certain statutory limita-tions, as if it were a tax deemed to be paid to itself. Where the foreign taxrate is lower than the domestic rate, only the excess of the domestic taxover the foreign tax is payable to the investor's country of residence.

13

Where the foreign tax is the higher one, the country of residence does notcollect any tax. The effective over-all tax burden is determined by thehigher of the domestic or the foreign tax rates.

Countries which apply the credit method reduce their normal taxclaims on the foreign profits by the amount of the tax which the investorhas already paid thereon to the source country. The latter could thusraise its tax rate to the level of the tax of the country of residence withoutimposing an additional tax burden on the investor. Correspondingly,special tax concessions granted by the source country, which reduce thatcountry's level of tax below the level charged by the country of res-idence on that income, would not to that extent accrue to the investor'sbenefit. But this result is limited in its practical scope, since most capital-exporting countries consider bona fide foreign subsidiaries engaged inproduction activities as being outside their national tax jurisdictions anddo not tax their profits at all unless and until they are repatriated in theform of dividends. It must be stressed, however, that if distinctions aremade in the source country tax rate depending on the country of residenceof the income recipient, this might violate a non-discrimination provisionin a tax treaty and might endanger the allowance of a credit if the res-idence country does not allow credit for foreign taxes imposed in a dis-criminatory manner.

There may also be difficulties arising from differences in definitionsof taxable income used by host and home country tax authorities. Thus, itmay arise that the home country authorities may define a corporation'sprofit obtained in a certain country more narrowly than that country'sincome tax authorities do, for example as a result of differences in de-preciation allowances, investment credits and so on. The latter country'sincome tax may then be. in excess of the tax which the home countrywould have assessed on that income which is also the upper limit on thetax credit allowed by the home country. Thus, even though the host coun-try statutory tax rate is less than the home country rate, it is possible thatsome part of the host country tax may be disallowed as a credit againsthome country tax. Countries applying the credit method normally deductfrom their own tax only the foreign tax levied on the dividends as such.However, in order to eliminate or mitigate recurrent corporate taxation,some countries allow as a credit against the corporation tax due by theparent company not only the tax levied on the subsidiary by the countrywhere it operates and which is withheld from the dividends as such butalso the corporation tax paid by the subsidiary as far is it relates to profitsdistributed to the parent company (so called "indirect tax credit" or"credit for underlying tax").

(ii) Tax credit as a bilateral relief methodWhen the credit method is used within the framework of a bilateral

income tax treaty, each of the Contracting States levies income taxes butthe country of residence permits income taxes paid to the source countryto be deducted from its own income taxes, with certain exceptions. Thetreaty usually indicates which taxes qualify for application of the credit.

Under the credit method the tax burden on investment abroad isthe same as that on domestic investment unless the foreign tax exceedsthe home country tax. This tendency toward equality of tax treatment has

14

serious implications for the developing countries' efforts to attract foreigninvestment, since the tax incentives granted by those countries to that endaccrue not to the foreign investors but to their countries of residence.The credit method may result in the benefit of host country tax incentivesaccruing to the residence country to the extent that profits are remitted.

(c) Tax-sparing methodsMany developed countries, especially the European countries, have

provided in their treaties with developing countries for the use of tax-sparing methods (sometimes referred to as matching credit method).Under these methods, the country of residence grants a tax credit cal-culated at a higher rate than the tax rate currently applied in the sourcecountry. In certain instances, the country of residence grants a creditnot only for the tax actually paid in a developing country, but also forthe tax spared by incentive legislation in that country, that is, the tax thatwould have been paid to the developing country had it not reduced itsincome taxes with a view to providing tax incentives for foreign investors.Tax-sparing clauses have been included in many bilateral treaties con-cluded by most of the major capital-exporting countries (e.g., Canada,France, the Federal Republic of Germany, Japan and the United Kingdomof Great Britain and Northern Ireland) and developing countries. How-ever, the United States treaties do not incorporate tax-sparing clauses thereason being that the standard of "capital export neutrality" should beapplied to the taxation of foreign investment and that investment in devel-oping countries can be more appropriately encouraged by direct sub-sidies rather than by indirect tax incentives.

(d) Implications for developing countries of the various methods for theprovision of relief from international double taxationWhen a developed country exempts foreign income from tax, the tax

burden on income from a developing country is determined entirely by thetax rate in that country. If that rate is lower than the rate in the developedcountry, the investors of the latter derive a tax benefit which constitutesan incentive for direct investment in that developing country. However,since the exemption method applies to income from all foreign sourceswithout distinction the tax benefit derived therefrom operates also as anincentive for direct investment in other developed countries, an incentivewhich may of course be stronger in the case of developed countries whosetax rates are lower than those of developing countries. The exemptionmethod nonetheless may exert a significant influence on decisions re-garding investment in developing countries since the benefits accruingto a foreign investor as a result of tax exemption or reduced tax ratesgranted to him by a developing country are not cancelled out by a taximposed by his own country.

On the other hand foreign investors are discouraged from investingin foreign countries when their home countries impose the full domestictax rate on foreign income and the tax levied by the source country issimply accepted as a deduction from the tax base. Only in cases wherethe source country imposes no tax on income from foreign investmentcan the tax burden on such investment be considered equal to that oncorresponding investments in the investor's home country.

15

When a developed country applies to foreign income a special lowtax rate which is sometimes much lower that that applied to domesticincome it may promote or discourage foreign investment depending onthe relationship between the tax rate applied to foreign income and do-mestic rate and between the tax rate generally applicable in developedand developing countries.

The credit method is predicated on the premise that tax should bea neutral factor in decisions concerning investment at home and abroadand that taxpayers with identical income should bear an identical taxburden irrespective of the source of their income. However, under thatmethod, the benefits of tax incentives granted to foreign investors bydeveloping countries may be offset by resulting higher tax liabilities inthe investor's home country. Furthermore, the effort of developed coun-tries to redefine their foreign tax credit rules, in order to prevent whatthey consider as abuse of such rules by excluding royalties, turnovertaxes and other levies not constituting income taxes or taxes imposed inlieu thereof might entail the exclusion of certain taxes that developingcountries consider it essential to levy.

The relationship between tax incentives offered by developing coun-tries and taxes imposed by the investors' home countries has been com-plicated by the fact that most of the latter countries which do not exemptforeign income from taxation have not adopted unilateral tax sparingclauses in their bilateral treaties with developing countries. The strictapplication of the principle of capital export neutrality implies that notax sparing should be allowed. Such application is often regarded asdetrimental to developing countries even though it has been argued thatit discourages tax incentives competition among those countries.

B. HISTORICAL OVERVIEW

The international efforts to deal with the problems of internationaldouble taxation were begun by the League of Nations and have beenpursued in the Organization for Economic Co-operation and Develop-ment and regional forums, as well as in the United Nations, have ingeneral found concrete expression in a series of model bilateral tax con-ventions. The Fiscal Committee of the League of Nations gave the follow-ing rationale for the elaboration of these conventions: "The existence ofmodel draft treaties has proved of real use . .. in helping to solve manyof the technical difficulties which arise in [the negotiation of] tax treaties.This procedure has the dual merit that, on the one hand, in so far as themodel constitutes the basis of bilateral agreements, it creates automaticallya uniformity of practice and legislation, while, on the other hand, inas-much as it may be modified in any bilateral agreement reached, it is suf-ficiently elastic to be adapted to the different conditions obtaining indifferent countries or pairs of countries." 2

1. The 1928 model bilateral tax conventions

In October 1928 the General Meeting of Government Experts on2 League of Nations, "Report of the Fiscal Committee to the Council on the

work of the fifth session of the Committee" (C.252.M.124.1935.II.A), p. 4, para.II.B.4.

16

Double Taxation and Tax Evasion convened by the Council of the Leagueof Nations adopted a Bilateral Convention for the Prevention of DoubleTaxation in the Special Matter of Direct Taxes, together with three othermodel bilateral conventions dealing respectively with succession duties,administrative assistance in matters of taxation and judicial assistance inthe collection of taxes. The work of the General Meeting was based ondraft model conventions prepared by a group of high-level tax officials.Composed of officials from seven European countries when originallyestablished in 1922, the group was enlarged in 1925 to include officialsfrom two more European countries and Japan and from Argentina andVenezuela. The United States joined the Group in 1927. The group hadprepared only one text, relating to direct taxes, but the General Meetingfound it advisable to prepare two new additional draft model conventionson the same matter because the first draft, intended primarily for Con-tracting States whose tax systems consisted of "impersonal taxes" onincome from domestic sources and a general income tax on income fromall sources, foreign as well as domestic, was felt to be not easily adaptableto the many tax systems based on a single graduated income tax whichapplied both to income derived by non-residents from domestic sourcesand to income derived by residents from all sources. The two new textsdrew no distinction between impersonal and personal taxes; the first ofthese texts was to be applied particularly to relations between countriesin which taxation by reference to domicile predominated, and the secondto relations between countries possessing different fiscal systems.

Although the 1928 model bilateral tax conventions in theory grantedconsiderable taxing power to the source countries, that power was limitedin practice by the pattern of international flows of private capital in theera preceding the Great Depression. In fact, most foreign investment incapital-receiving countries at that time took the form of portfolio invest-ment, the income from which was taxable under the conventions in thecountry of the investors' fiscal domicile which the conventions defined asthe normal residence of the taxpayer. There was relatively little directinvestment, which in the light of the newly formulated concept of "per-manent establishment" would have been liable to a large degree to taxa-tion in the source country.

2. The 1935 Draft Convention for the Allocation of BusinessIncome between States for the Purposes of Taxation

During sessions held at the end of the 1920s and the beginning ofthe 1930s, the Fiscal Committee of the League of Nations3 devoted con-siderable attention to the question of formulating, for tax purposes, rulesfor the allocation of business income of undertakings operating in severalcountries, the term undertakings being understood as making no distinc-tion between natural and legal persons. Within the framework of thoseactivities, a Draft Convention for the Allocation of Business Incomebetween States for the Purposes of Taxation was formulated, first atmeetings of a Sub-Committee held in New York and Washington under

3 The Fiscal Committee had been set up in 1929 pursuant to a recommenda-tion of the General Meeting of Government Experts on Double Taxation and TaxEvasion.

17

the auspices of the American Section of the International Chamber ofCommerce, and then at the full meeting of the Fiscal Committee in June1933. The Draft Convention, which was revised by the Fiscal Committeeat a session held in June 1935, was never formally adopted but was ofgreat significance because of the importance of the issues with which itdealt.

The Draft Convention contained a definition of business incomewhich excluded from such income all items of income allocable to specificsources such as dividends and interests; the remaining items of incomewere grouped together as "business income", which was taxable on thebasis of the accounts of each permanent establishment from which the in-come had originated. The underlying purpose of the definition was to as-similate the permanent establishment that an enterprise had in otherContracting States to independent legal entities doing business with eachother on the same or similar conditions as with independent enterprisesand to permit the determination of the net income of each establishmenton the basis of the separate accounts pertaining to such establishment.In order to fulfil the latter purpose, the Draft Convention authorizedthe tax authorities of the Contracting States to rectify the accounts pro-duced, notably to correct errors or omissions, or to re-establish the pricesor remunerations entered in the books at the value which would prevailbetween independent persons dealing at arm's length. If the envisagedrectification could not be effected in that way or if an establishment couldnot produce an accounting showing its own operations, or if the account-ing produced did not correspond to the normal usages of the trade in thecountry where the establishment was situated the tax authorities mightdetermine empirically the business income by applying a percentage tothe turnover of that establishment and by a comparison with the resultsobtained by similar enterprises operating in the country. If the foregoingmethods of determination were found to be inapplicable, the net businessincome of the permanent establishment might be determined by a com-putation based on the total income derived by the enterprise from theactivities in which such establishment had participated. The determina-tion was made by applying to the total income coefficients based on acomparison of gross receipts, assets, number of hours worked or otherappropriate factors, provided such factors were so selected as to ensureresults approaching as closely as possible to those which would be re-flected by a separate accounting.

3. The 1943 Mexico model bilateral tax conventions

At the June 1939 session of the Fiscal Committee of the League ofNations, it was suggested that the three 1928 model conventions dealingwith direct taxes should be revised in the light of the technical improve-ments embodied in the various bilateral tax treaties concluded during the1930s, taking into account the new trends and problems which had arisenin 'the fields of international trade and investment and the views andrecommendations expressed by the Fiscal Committee itself at its varioussessions.

The work of revision was begun by a Sub-Committee which met atThe Hague in April 1940 and continued by two Regional Tax Confer-

18

ences held under the auspices of the League of Nations at Mexico Cityin June 1940 and July 1943. The Regional Conferences were attendedby representatives of Argentina, Bolivia, Canada, Chile, Colombia, Ecua-dor, Mexico, Peru, the United States, Uruguay and Venezuela. TheSecond Regional Conference had before it the Draft Model Conventionfor the Prevention of Double Taxation of Income, which had been pre-pared by the First Regional Conference, as well as documents submittedby the Secretariat of the League of Nations and various experts on theprevention of double taxation of successions, the establishmefit of re-ciprocal co-operation between national tax administrations for the assess-ment and collection of direct taxes and on postwar fiscal problems. Atthe conclusion of its deliberations, the Second Regional Conferenceadopted a Model Bilateral Convention for the Prevention of the DoubleTaxation of Income and a Protocol thereto, a Model Bilateral Conven-tion for the Prevention of the Double Taxation of Successions and aProtocol thereto, and a Model Bilateral Convention for the Establish-ment of Reciprocal Administrative Assistance for the Assessment andCollection of Direct Taxes and a Protocol thereto.

The Model Bilateral Convention for the Prevention of the DoubleTaxation of Income, which was to replace the three 1928 model conven-tions dealing with direct taxes and also incorporate the provisions of the1935 Draft Convention for the Allocation of Business Income, advozatedthe taxation of income derived by non-residents almost exclusively atsource. Although at the Mexico Conferences Canada aligned its positionwith those of the Latin American countries, the Mexico Model BilateralConvention for the Prevention of the Double Taxation of Income hasnevertheless been viewed as representing "the first attempt by the devel-oping countries to write a model treaty reflecting their particular prob-lems". 4 In this respect, it may be recalled that the positions embodiedin the Mexico Model Bilateral Convention for the Prevention of theDouble Taxation of Income were similar to those taken earlier by therepresentatives of capital-importing countries at the 1928 General Meet-ing of Government Experts on Double Taxation and Tax Evasion. Atthat Meeting, widely divergent views were expressed by the representa-tives of capital-exporting and capital-importing countries as to whetherthe source country or the country of residence should be empowered totax dividends and interest.

4. The 1946 London model bilateral tax conventions

In March 1946, the Fiscal Committee of the League of Nationsconvened in London for its tenth session, at which it reviewed the Mexicomodel bilateral tax conventions. The Fiscal Committee was of the opinionthat the latter represented "a definite improvement on the 1928 ModelConventions" but that "nevertheless, since the membership of the MexicoCity and London meetings differed considerably, it [was] natural thatthe participants in the London meeting held, on various points, differentviews from those which inspired the model conventions prepared in

4 Manila Conference on the Law of the World, The Emerging InternationalTax Code: Report of the Committee on Taxation of the World Association ofLawyers (August 1977), p. 4.

19

Mexico". The Committee stated that the general structure of the modelconventions drafted at the tenth session was similar to that of the Mexicomodels and that a certain number of changes had been made in the word-ing, and some articles had been suppressed because they contained pro-visions already contained in other clauses. The Committee observed thatvirtually the only clauses where there was an effective divergence betweenthe views of the 1943 Mexico meeting and those of the London meetingwere those "relating to the taxation of interest, dividends, royalties, an-nuities and pensions". The Committee added that it was aware of thefact that the provisions c6ntained in the 1943 model conventions mightappear more attractive to some States-in Latin America for instance-than those which it had agreed during its current sessions and that itthought "that the work done both in Mexico and in London could beusefully reviewed and developed by a balanced group of tax administra-tors and experts from both capital-importing and capital-exporting coun-tries and from economically-advanced and less-advanced countries, whenthe League work on international tax problems is taken over by theUnited Nations".,

With regard to the Committee's remarks concerning the divergencebetween the Mexico and London conventions relating to interest, divi-dends and royalties, it is the taxation of such items of income which hasalways been in dispute. It is to be noted that in the case of taxes on busi-ness profits and income from immovable property the primary right ofthe source country to impose taxes has never been questioned, has beenrecognized in all model conventions, and has been a constant feature oftreaty practice. According to the Committee on Taxation of the WorldAssociation of Lawyers at the Manila Conference on the Law of theWorld, on the occasion of the London meeting, "the capital-exportingcountries reasserted themselves, and the London model [Model BilateralConvention for the Prevention of the Double Taxation of Income andProperty] sought to encourage the outflow of capital from industrializedcountries into developing countries by limiting taxation to the countrywhere income was ultimately received".6

5. The OECD model bilateral tax conventions

Like the 1928 model bilateral conventions, which never won wideacceptance, the model conventions of Mexico and London were neverfully and unanimously accepted. However, the principles containedtherein were followed with certain variants in numerous bilateral taxtreaties between developed countries until the Organisation for EuropeanEconomic Co-operation (OEEC which was to become subsequentlyOECD) created its Fiscal Committee in 1956 and entrusted it with thetask of working out a draft model bilateral tax convention "which wouldeffectively resolve the double taxation problems existing between OECDmember countries and which would be acceptable to all member coun-

5 League of Nations, Fiscal Committee: Report on the Work of the TenthSession of the Committee (C.37.M.37.1946.II.A), p. 8.

6 Manila Conference on the Law of the World, op. cit. p. 12.

20

tries".' The need for a new draft bilateral tax convention on income andcapital which would facilitate the extension of the network of bilateraltax treaties to all member countries of OEEC arose from the fact thatthe Mexico Model Bilateral Convention for the Prevention of the DoubleTaxation of Income and the London Model Bilateral Convention for thePrevention of the Double Taxation of Income and Property presentedin respect of several essential questions "considerable dissimilarities andcertain gaps". It arose more particularly from "the increasing economicinterdependence of the member countries of OEEC in the post-war periodand the economic co-operation established among them showed increas-ingly clearly the importance of measures for preventing internationaldouble taxation".8

The Fiscal Committee used as its main reference text the LondonModel Bilateral Convention for the Prevention of the Double Taxationof Income and Property and revised it extensively taking into accountpractices embodied in bilateral tax treaties which had been negotiatedon the basis of that model convention. Originally published in 1963 theOECD Model Double Taxation Convention on Income and Capital wasrevised from 1967 onwards and published in its revised form in 1977.

The OECD Model Double Taxation Convention on Income and onCapital rests essentially on two premises: (a) the country of residencewould eliminate double taxation through the credit method or the ex-emption method; and (b) the country of source, in response, would con-siderably reduce the scope of its jurisdiction to tax at source and therates of tax where jurisdiction was retained.

Recognizing that the effort to eliminate double taxation betweenMember countries' needs to go beyond the field of periodic taxes on in-come and capital, OECD in July 1963 instructed its Fiscal Committeeto work out a draft convention which would provide a means of settlingon a uniform basis the most common problems of double taxation ofestates and inheritances. The Draft Convention for the Avoidance ofDouble Taxation with Respect to Taxes on Estates and Inheritances waspublished in 1966.

7 Organization for Economic Co-operation and Development, Model DoubleTaxation Convention on Income and on Capital, Report of the Committee onFiscal Affairs (Paris, 1977), p. 8.

8 Ibid., p. 7.

21

H. INTERNATIONAL TAX EVASION ANDAVOIDANCE

A. CONCEPTS AND ISSUES

The ease and rapidity of communications, the progressive elimi-nation of obstacles to the movement of persons and property and theexpansion of international economic relations, combined with ever-increasing differences in national tax systems and hence in the tax burdenfrom country to country and with the growing sophistication of the tech-niques used by lawyers to help their clients take advantage of legal loop-holes, have enabled an increasing number of individuals and companiesto resort to tax evasion or tax avoidance.

1. The concepts of tax evasion and tax avoidance

Tax evasion proper is considered to occur when non-compliancewith the laws of the taxing jurisdiction is the result of a wilful and con-scious failure to do so. In a broader sense, tax evasion also normallyencompasses the case of persons who as a result of carelessness or negli-gence fail to pay taxes which are legally due although they do not haverecourse to deliberate concealment for that purpose.

Tax avoidance, on the other hand, is a less precise concept and onewhich is not easy to define in terms which would meet general accep-tance. But put very broadly, may be considered to occur when personsarrange their affairs in such a way as to take advantage of weaknesses orambiguities in the law to reduce the tax payable below what it wouldotherwise be, without actually breaking the law. Although tax avoidancemay be regarded as immoral, the means employed are legal and the con-duct involved is not fraudulent.

Examples covering both tax avoidance and evasion situations follow.

2. Practices resorted to in order to reduce taxes imposedon international income

These practices, generally speaking, fall into four categories: prac-tices resorted to in order to reduce taxes imposed by the country of resi-dence or citizenship; practices resorted to in order to reduce taxes im-posed by the country of source; institutional devices and arrangementswhich facilitate the evasion or avoidance of taxes imposed on internationalincome and the use of related tax-haven entities to reduce such taxes.

(a) Practices resorted to in order to reduce taxes imposed by the coun-try of residence or citizenshipMany countries impose taxes on income received from abroad by

residents or non-resident citizens. The practices resorted to in order toreduce payment of these taxes include the following:

22

(i) Failure to file a return

One of the most common practices resorted to in order to reducepayment of taxes on international income consists in the deliberate failureof resident aliens to file tax returns in the country in which they are re-siding. Persons who spend a portion of each year in different jurisdictionsfrequently make inconsistent claims of residence. Where a country taxesthe world-wide income of its citizens, a citizen who is residing abroadmay reduce payment of taxes by failing to file a return in the country ofhis citizenship.

(ii) Failure to report all income subject to tax

Another important practice in this category is the wilful or negli-gent failure to report all items of international income which are subjectto tax. The items most often omitted are salaries, wages and non-commercial income, interest and dividends, business income, income fromreal estate and royalties.

Salaries, wages and non-commercial income. Residents of a par-ticular country who receive remuneration from abroad in payment forservices or in the form of pensions and annuities frequently fail to reportthe income involved in the tax returns. Consequently, such income, ifnot taxed at the source, is apt to escape taxation both in the countrywhere it is acquired and in the country in which the recipient is resident.

Interest and dividends. In the view of many tax administrators, taxevasion or avoidance is probably most prevalent in connexion with thistype of income, since interest and dividends can easily be collected anon-ymously at a financial institution in a third country where the securitiesare held in custody. This type of income also lends itself to many fraudu-lent practices through the skilful use of certain special provisions of do-mestic laws. Thus, certain institutions whose prime purpose is economicor financial are frequently used to facilitate tax evasion or avoidance.

The situation created by investment trusts or holding companies isof particular interest in connexion with the evasion or avoidance of pay-ment of taxes on this type of income. The anonymity of the owners ofthe securities held by an investment trust is normally assured by the formof their holdings in the investment trust and also by the fact that oftenthe trust has no liability towards the tax administration of the country inwhich it is established. Where the trust is not itself a taxable entity, it paysno tax on profits from its dealings or on income. The owners of the se-curities who are the true recipients of the profits and income may notbe subjected to personal taxation, if the tax administration is not awareof their identity because, for example, the securities are in bearer formor, if registered, are held by nominees. As for holding companies, thepreferential tax regime applied to them in some countries likewise en-courages the creation of legal structures, the consequence-although notalways the purpose-of which is to facilitate tax evasion or avoidancewith respect to the income from holdings in companies anywhere in theworld. As in the case of investment trusts, this situation results first fromthe fact that no tax, or very little, may be payable by the holding com-pany in respect of the income which it receives and redistributes and

23

secondly from the lack of information as to the identity of the individualsor companies among whom the distributions are made.

Business income. Taxes on business income are frequently reducedby means of deliberate failure to keep accurate books and records withinthe taxing jurisdiction. Frequently a second set of books, which is accu-rate, will be maintained outside the taxing jurisdiction, but those recordsare normally beyond the reach of the authorities of that juris. In someinstances, the maintenance of false books within the taxing jurisdictionis facilitated by limitations in domestic law on the extent to which thetaxpayer's books and records may be examined by the tax authorities.

In connexion with this type of income, in respect of which the ruleof territoriality often applies, some of the devices most frequently em-ployed to shift profits properly allocable to the source country to othercountries include the establishment of artificial transfer prices for importsand exports, the improper allocation of profits and losses, and licensingagreements under which the user of technology is obliged to purchaseimported inputs, equipment and spare parts. Such devices, which trans-national corporations are particularly well situated to use, are of greatconcern to developing countries,,whose tax officials have often claimedthat they lack the time and expertise to challenge effectively the pricesset between affiliated companies, which thus often remain virtually withinthe discretion of the companies concerned.

There is a grey area between tax evasion and tax avoidance involv-ing cases where taxpayers seek to take advantage of loop-holes in bilateraltax agreements. For example, enterprises can set up a permanent estab-lishment in the contracting State in which taxes are smaller, so that if theother tax authority operates an exemption system some of their opera-tions will be taxed at a lower rate. It may also be advantageous, purelyfor tax purposes, for a company of a particular country to conduct op-erations with partners in another country to create a relay in the formof a company established in a third country where taxes are low. Unlesscertain precautions are taken, it will even be possible with such an ar-rangement to claim the benefits of any tax agreement that may existbetween the second and third countries.

Income from real estate. The taxpayer fails to report in the countryof his fiscal domicile or residence income which he has received in rentor which may be assimilated to rent in the country where the property issituated. Such income may also escape taxation in the latter country ifthe tax authorities are not actually aware of the identity and domicile ofthe recipient.

Royalties. Royalties paid abroad for the use of or the right to usepatents or trademarks may be used to shift profits out of high-tax coun-tries into low-tax or no-tax countries by fixing them at artificial highrates compared with the arm's length value of the use or right in question.Such devices are facilitated by difficulties in estimating the arm's lengthvalue of monopoly rights.

(iii) Fictitious deductionsIn a variety of circumstances, fictitious business expenses may be

claimed as deductions, particularly if the purported recipient of the ex-

24

pense payment is outside the taxing jurisdiction and is therefore not sub-ject to audit by the tax authorities of that jurisdiction. For example, if thetaxpayer purchases goods outside the taxing jurisdiction, false invoicesmay be prepared to show a purchase price greater than that actually paidby the taxpayer.

In many cases, commissions, royalties, technical service fees andsimilar expenses will be paid by a resident of the taxing jurisdiction to arelated non-resident and claimed as deductions, even though the relatednon-resident has done nothing to earn such fees.

(iv) Credit for fictitious taxA taxpayer residing in one country and receiving international in-

come from another country may seek to reduce tax in the first country,which allows a foreign tax credit as a method of relieving double taxa-tion, by claiming fictitious or excessive credits for taxes allegedly paid tothe other country.

(v) Improper characterization of income or expense itemsTax may be reduced by improperly characterizing an income or ex-

pense item in order to make use of an exemption or reduced rate.

(vi) Inconsistent characterizationsA taxpayer may characterize a particular transaction in one way in

country A, and in a contrary way in country B, in order to obtain taxbenefits in each country. For example, advances by a parent in country Ato a subsidiary in country B may be treated as equity in country A (inorder to avoid the necessity for reporting interest income to country A),but as debt in country B (in order to avoid capital stock taxes in countryB). Payments made by a subsidiary in country A to its parent in countryB may be treated as the purchase price of goods in country A but asroyalties or dividends in country B. In some cases, however, apparent in-consistencies of this type may be justified by differences in the internallaws of the two jurisdictions.

(vii) Utilizing temporary taxpayer statusWhere taxation is based on status temporarily attained, tax evasion

or avoidance may occur through transactions which take advantage ofthat temporary status. For example, because a borrower is not liable totax on the proceeds of a loan, a foreign national may arrange an osten-sible loan while he is a resident of the taxing jurisdiction, and then sellthe collateral for the alleged loan to the lender following his departurefrom the taxing jurisdiction (when he is no longer taxable on sales profitwithin that jurisdiction), with the "loan" being credited against the saleprice.

(viii) Flight to evade payment of tax

Where the taxing jurisdiction determines that a resident alien hastaxable income or assesses a tax against him, the individual may flee thejurisdiction to escape tax. Even though the authorities of the taxingjurisdiction have properly assessed the tax, it is collectible only to theextent of the taxpayer's property within the reach of the administrative

25

and judicial collection power. Generally, that power is limited to thetaxing country and its possessions. Thus, to the extent that property isremoved from the taxing jurisdiction, it is generally immune from col-lection because the courts of one country will not enforce a judgementfor taxes rendered by the courts of another country.

(b) Practices resorted to in order to evade or avoid taxes imposed bythe country of sourceTax on income derived from sources within the taxing country by

non-residents is generally collected by requiring the payer of the incometo withhold the tax before remitting the balance of the payment to thenon-resident. There are a number of common techniques for evading thepayment of these withholding taxes.

(i) False withholding certificates

Tax may be evaded by providing false information to withholdingagents. For example, a payer of dividends having no definite knowledgeof the status of a shareholder may not be required to withhold tax if thereis no internal system of withholding within the country of the payer. Ac-cordingly, a non-resident alien recipient will frequently establish a falseaddress within the country, in order to escape withholding. This methodof evasion depends on the willingness of the nominee to violate the lawby failing to withhold tax when he makes remittances to the true owneroutside the country.

(ii) Use of bearer securitiesIn many instances, withholding taxes can be avoided by holding

securities in bearer form, particularly if they are in the custody of a broker,nominee or agent within the country of the issuing corporation. Again,this method of avoidance assumes that the person holding the bearersecurities is prepared to violate the law by failing to withhold when re-mittances are made to the true owner.

(iii) Erroneous characterization of income items

Where the withholding rates on certain types of income are lowerthan the rates on other types of income, related entities will frequentlydisguise the true character of a payment in order to take advantage of thelower rate. For example, dividends may be paid in the guise of fees orcommissions.

(iv) Unreported income and fictitious expensesAn individual who is temporarily present in the taxing jurisdiction,

but is neither a resident nor a citizen, may evade tax on income earnedwhile he was in the jurisdiction by either understating his true income oroverstating his true expenses.

(c) Institutional devices and arrangements which facilitate evasionThere are a variety of institutional devices which are used to conceal

the existence of international income or to generate fictitious deductionsand which thereby facilitate international income tax evasion.

26

(i) Use of dummies, nominees and numbered bank accountsThe existence of salaries, investment income, business profits and

other items of international income is frequently concealed by having theitems paid to dummies, nominees or numbered bank accounts inside oroutside the taxing jurisdiction. For example, an official of country A maystate that he will permit a subsidiary in country A to make certain remit-tances to its parent in country B only if the parent makes an unreportedpayment in funds of country B to a nominee of the official (or a numberedbank account maintained by him) in country B or C. Similarly, a resi-dent of country D who sells property at a gain to a resident of country Emay stipulate that the sales proceeds are to be deposited in a numberedbank account inside or outside country D.

Once an item of international income has been concealed in a num-bered bank account or in the name of a nominee, the amount in that con-cealed account can be used to generate investment income which maylikewise be concealed from the taxing authorities of the country in whichthe true owner of the account is residing.

(ii) Use of bearer securitiesIn order to conceal the receipt of dividend or interest income, inter-

national investors will frequently place investments in bearer form. Theuse of bearer securities also facilitates the transfer of investments fromone owner to another without reporting the transaction and paying thetax due by reason of the transfer. It is difficult to police such transactionsfrom a tax standpoint because the use of bearer securities is widespreadand entirely legal in most countries.

(iii) Use of foreign holding companies and trustsUnder the laws of some countries, a resident may legally avoid tax

on investment income by placing his income-producing property in aforeign corporation or trust which he controls. However, under the lawsof other countries, the investment income is taxable by the country ofresidence whether or not it is actually distributed by the foreign corpora-tion or trust to the resident owner. In cases of the latter type, tax is fre-quently evaded by illegally concealing the existence of the foreign holdingcompany or trust from the tax authorities of the country or residence.

(iv) Artificial bank loansA major technique for international tax evasion consists of pur-

portedly borrowing funds which are actually owned by the borrower. Thisnot only enables the "borrower" to make open use of funds previouslyconcealed in the name of a nominee or in a numbered bank account, butalso gives the borrower a pretext for claiming fictitious interest deduc-tions. For example, a resident of country A who has deposited unreportedinternational income in a numbered bank account in country B will ar-range to "borrow" an equivalent amount from that bank at 82 per centinterest. If the bank is paying 8 per cent interest to him on his numberedaccount, he will actually be out of pocket only 2 per cent, but on thereturn which he files in country A he will treat the receipt of the unre-ported income as a "loan" and will claim a deduction for the entire 8/2per cent interest charge which he pays to the bank.

27

To further disguise the true facts, a resident of country A with anumbered bank account in country B may arrange to have the bank incountry B forward funds to an unrelated bank in country C from whichhe will then "borrow" an equivalent amount.

(v) Investment trustsBy concentrating funds from many different sources in a single in-

vestment pool, an international investment trust may make it possible formany different investors to reduce tax simultaneously.

(d) Use of related tax-haven entities to reduce taxesEntities in tax-haven countries are frequently utilized to reduce taxes

in a fashion which is legal under the framework of present tax systems.But, in addition to fostering legal methods of reducing tax, the presenceof tax-haven countries invites tax evasion activities that turn on an es-sentially false or illegal relationship with the tax-haven country. Some ofthese latter situations are described below.

(i) Transfer of income-producing assets to a tax-haven entityTax evasion may occur where income-producing assets are trans-

ferred at an artificially low cost from the taxing jurisdiction to a con-trolled entity in a foreign tax-haven country where the potential incomefrom the assets will be subject to tax at a lower rate, or escape tax entirely.The assets transferred to the foreign tax-haven company may consist of:

Stocks, securities, rental properties, and intangibles such aslicensed patents, trade-marks and copyrights which will generatecontinuing passive investments income, or

Property of any kind which will be resold by the tax-haven en-tity to unrelated third parties at a gain.In many cases, there is no limitation on the amount of income which

may be accumulated tax free in the foreign tax-haven entity.

(ii) Nominal transfer of income-producing functions to a tax-havenentity

An entity in a high-tax country will frequently reduce tax by arrang-ing to render services to unrelated parties through a controlled entity ina tax-haven jurisdiction. In the typical case, the controlled entity is ashell corporation which is incapable of performing the services unless ituses personnel and/or property of the controlling entity.

(iii) Payment of deductible expenses to a tax-haven entityAn entity in a high-tax jurisdiction may pay management fees, tech-

nical service fees, or other deductible fees to a related entity in a tax-haven jurisdiction, which has not actually earned those fees and will nothave to pay appreciable tax on them.

(iv) Payment of deductible expenses which benefit a tax-havenentity

An entity in a high-tax country may incur deductible expenses inacquiring or developing property which is then made available without

28

adequate reimbursement to a related entity in a tax-haven country. Forexample, the entity in the high-tax country may take interest deductionswith respect to borrowed funds which are relent to the related entityinterest fee. Similarly, the entity in the high-tax country may take de-preciation deductions for tangible property, or research expense deduc-tions for intangible property, which is leased or licensed to the relatedentity for an artificially low consideration.

As previously stated, some of the techniques described above maybe legal methods of reducing tax, rather than illegal methods of evadingtax, depending on the law of the particular countries involved.

B. HISTORICAL OVERVIEW

The question of international tax evasion has been a matter ofinternational concern for well over a century. It may be noted that thefirst tax treaty was an agreement concerning reciprocal administrativeassistance between Belgium and France signed on 12 August 1843.Shortly thereafter, in 1845, Belgium signed similar agreements with twoother States, the Netherlands and Luxembourg.

Both the 1920 International Financial Conference at Brussels andthe 1922 International Econdmic Conference at Genoa emphasized thedesirability of international action for the prevention of tax evasion. TheBrussels Conference stated that it would be desirable "to draw attentionto the advantages of making progress under each of the following heads... An international understanding which, while ensuring the due pay-ment by everyone of his full share of taxation, would avoid the impositionof double taxation which is at present an obstacle to the placing of in-vestments abroad".9 The Genoa Conference expressed itself in the fol-lowing way:

"We have considered what action, if any, could be taken toprevent the flight of capital in order to avoid taxation, and we are ofthe opinion that any proposals to interfere with the freedom of themarket for exchange, or to violate the secrecy of bankers' relationswith their customers are to be condemned. Subject to this proviso,co-operation to prevent tax evasion might be usefully studied inconnexion with the problem of double taxation.""oThe 1928 General Meeting of Government Experts on Double

Taxation and Tax Evasion adopted a separate bilateral model conven-tion on administrative assistance in matters of taxation. That assistancewas to consist in the exchange of fiscal information available in either ofthe contracting States and in co-operation between their administrativeauthorities in carrying out certain procedural measures. The exchangeof information was to take place following requests concerning specificcases or on a routine basis (i.e., without any special request) in the caseof particulars (name, surname, domicile or residence, family responsi-bility) with reference to immovable property, mortgages or other similar

9 Recommendations of the Brussels Conference, resolution proposed by theCommission on International Credits, No. 12.

10 Recommendations of the Genoa Conference, resolution proposed by theFinancial Commission, No. 13.

29

claims, industrial, commercial or agricultural undertakings, earned in-come and directors' fees, transferable securities, claims, deposits andcurrent accounts and successions.

The 1928 General Meeting also approved a separate bilateralconvention on judicial assistance in the collection of taxes, the wordcollection covering not only the actual measures of execution but alsopreliminary measures such as the serving of the documents of execution.These two conventions, together with the two double taxation conven-tions adopted at the same time (dealing respectively with income andproperty taxes and succession duties) did not win significant acceptance.

Pursuant to a request by the Assembly of the League of Nations, theFiscal Committee of the League studied the question of tax evasion at itssixth session, held in 1936. In its report on that session, the Committeedealt with existing tax evasion practices with particular reference to in-come from securities. It proposed a new solution based on a system forthe exchange of information and asked the Governments of Members ofthe League, and also non-members, whether they would approve a gen-eral convention establishing such a system." The response was not en-couraging and the Assembly asked the Committee to resume its discussionof the question. The Committee proceeded to draft a questionnaire witha view to determining what could be done to combat tax evasion on thebasis of existing tax laws. In the light of the replies to the questionnaire,the Committee expressed the view that ". . . the administrations haveshown great ingenuity in combating evasion in every form. But the effortsof the various administrations were of so special a character that it ap-peared to be difficult to employ the methods used by one country in othercountries, and it was clear that any proposal for a general scheme wouldhave been received with serious hesitation." 1 2 The Committee was there-fore of the opinion that "for the problem of fiscal evasion as for the prob-lem of double taxation, bilateral conventions are the only possibility asthey can be adapted to circumstances and the nature of the results aimedat".13

Consequently, at the two Regional Tax Conferences held under theauspices of the Fiscal Committee at Mexico City in June 1940 and July1943, and at the tenth session of the Fiscal Committee itself held in Lon-don in March 1946, emphasis was placed on the need for bilateral con-ventions for the prevention of tax evasion. As a result, two special modelbilateral conventions were prepared, one in Mexico and the other inLondon, dealing with the establishment of reciprocal administrative as-sistance for the assessment and collection of taxes on income, property,estates and successions. Both conventions contain an identical clauseunder which the competent authorities of each of the Contracting Stateswould be entitled to obtain through direct correspondence-without hav-ing to use diplomatic channels-from the competent authorities of theother Contracting State information concerning particular cases that is

11 League of Nations% "Report of the Fiscal Committee to the Council on theWork of the sixth session of the Committee" (C.450.M.266.1936.H.A).

12 League of Nations, "Report of the Fiscal Committee to the Council on thework of the eighth session of the Committee" (C.384.M.229.1938.I.A), p. 2, para.1.3.

13 Ibid., para. 1.4.

30

necessary for the assessment of the taxes to which the convention relates.The conventions also indicated in identical language the kind of informa-tion which should be supplied and specified the cases in which specialrequests for information and/or assistance in enforcing tax laws mightbe refused. Those cases related to requests for information not procur-able under domestic laws, to requests implying administrative or judicialaction incompatible with domestic laws and practices, to requests com-pliance with which would involve violation of a professional, industrialor trade secret and to requests compliance with which might compromisethe security or sovereign rights of the other State.

Since the winding up of the League of Nations and hence of its FiscalCommittee, the prevention of fiscal evasion has not until recently beenconsidered in depth in international forums separately from the questionof double taxation. There seems to have been a consensus that Stateswere reluctant to assist each other in the assessment and collection ofdirect taxes, unless they first agreed to reduce or eliminate the inequitableburden resulting from double taxation. Exchanges of information wereviewed rather as appropriate to prevent tax evasion that resulted fromthe abuse of bilateral treaties for the avoidance of double taxation. Con-sequently, since the set of model conventions adopted in London in 1946,no separate model dealing exclusively with reciprocal administrative assis-tance for the assessment and collection of direct taxes has been drawn up.

However, mention should be made of the efforts in the field of admin-istrative assistance in tax matters pursued by the Nordic Countries sincethe early 1940s. A bilateral agreement on such assistance was signed byFinland and Sweden in 1943; its main purpose was to facilitate the en-forcement of taxes in cases where taxpayers had left one of the ContractingStates for the other. It was recognized that the agreement would have apreventive effect in the field of tax avoidance. The agreement coveredboth reciprocal assistance for the enforcement of tax claims and the ex-change of information (service of documents and procurement of infor-mation on tax matters). The agreement was followed by other agreementsin the same field between Norway and Sweden (1949), Denmark andSweden (1953), Finland and Norway (1954), Denmark and Finland(1955) and Denmark and Norway (1956).

The question of the revision of those agreements was taken up bythe representatives of the Nordic tax administrations at a meeting held inHelsinki in 1967, at which it was found that the provisions of those agree-ments and of the relevant legislation of those countries were similar. Forthat reason, the representatives of the Nordic tax administrations decidedat a meeting held in Copenhagen in 1970 that a multilateral conventionon administrative assistance in tax matters between Denmark, Finland,Iceland, Norway and Sweden should be prepared. The convention wassigned on 9 November 1972, supplemented by a special agreement in 1973and amended by an additional agreement in 1976.

The Multilateral Convention is divided into five parts, the most essen-tial of which are those concerning the procurement of information andtax enforcement. The Convention also contains general provisions, pro-visions concerning the service of documents and special provisions. Inaddition to the income and capital taxes dealt with in the conventions

31

for the avoidance of double taxation between the Nordic countries, theMultilateral Convention covers inheritance or estate taxes, gift tax, certainindirect taxes (such as motor vehicle taxes and value added taxes), socialsecurity and some other public charges and advance payments of taxes.The Multilateral Convention originally provided that the assistance couldtake the form of tax collection and enforcement, service of documentsand exchange of information, either automatically or on request. The1976 Additional Agreement extended the scope of the exchange of in-formation system to cover the spontaneous exchange of information. Italso made it possible for tax officials of one Nordic country to take partin tax investigations in another Nordic country.

Furthermore, other States are currently devoting increasing attentionto the question of international tax evasion and avoidance. For example,the United States has concluded with Canada, France and the UnitedKingdom administrative arrangements concerning the simultaneous ex-amination of transnational enterprises.

International organizations too have been taking increasing interestin the question.

The European Economic Community adopted on 10 February 1975a resolution on the measures to be taken by the Community with a viewto combating international tax evasion and avoidance. Furthermore,Council of the Community adopted on 19 December 1977 a directiveconcerning mutual assistance by the competent authorities of memberStates with regard to direct taxes.

The OECD Committee on Fiscal Affairs has been devoting con-siderable attention to international tax evasion and avoidance and oneof its working parties is specifically responsible for investigating therelated issues. The OECD adopted on 21 September 1977 a recommen-dation requesting member States to strengthen their machinery for com-bating international tax evasion and avoidance, to encourage the exchangeof information between national tax administrations and to comparetheir experience with regard to the practices and techniques used. It maybe noted that another working party of the Committee on Fiscal Affairsis currently considering a draft model convention for mutual administra-tive assistance in recovery of tax claims.

The subject of international tax evasion and avoidance is currentlyon the agenda of the United Nations Group of Experts on Tax Treatiesand is to receive intensive consideration.

32

Part Two

GUIDELINES FOR THE FORMULATION OFTHE PROVISIONS OF A BILATERAL TAX

TREATY BETWEEN A DEVELOPINGCOUNTRY AND A DEVELOPED COUNTRY

PREFACE TO THE GUIDELINES

In order to take advantage of the accumulated technical expertiseembodied in the OECD Model Double Taxation Convention on Incomeand Capital (hereafter referred to as the OECD Model Convention) andthe commentary thereon, and for reasons of practical convenience stem-ming from the fact .that the OECD Model Convention was being usedby OECD member countries in the negotiation of tax treaties not onlywith each other but also with developing countries, the Group of Expertson Tax Treaties between Developed and Developing Countries decidedto use that Model Convention as its main reference text, without anypresumption of correctness regarding the policy positions advocatedtherein, the language used and the commentary thereon. From its Firstto its Sixth Meetings inclusive, the Group used' the 1963 version of theOECD Model Convention. The 1977 version thereof became, available tothe Group at its Seventh Meeting and the guidelines formulated previ-ously were then brought into line with the 1977 version in the few in-stances where such modifications were necessary. Consequently, allreferences to the OECD Model Convention in the observations on theguidelines concern the 1977 version.

The guidelines formulated by the Group of Experts contain sugges-tions concerning specific provisions that could be embodied in a bilateraltax treaty. Each guideline, therefore, takes the form of a possible text ofa treaty article. Furthermore, each guideline is followed by observationswhich summarize the relevant discussion in the Group of Experts, men-tion the decisions taken and indicate when and how the guidelines differfrom the corresponding text of the OECD Model Convention.

In some cases, it is stated in the observations that a given guideline"reproduces" a provision of the OECD Model Convention. This impliesthat the text remains unchanged except for minor drafting changes. Wherethe text of a guideline reproduces the provisions of an article of the OECDModel Convention, it should be construed as having the same meaningand being subject to the same reservations as that article, and should beinterpreted in the light of the OECD commentary. Problems may arisein the case of terms used in the OECD Model Convention and the guide-lines which are not defined in the OECD Commentary and have not beenclassified by the Group of Experts. Participants from developing countriesin the Meeting of the Drafting Committee cited as examples of suchterms "landed property", "partnership", "general commission agent","jouissance shares", "jouissance rights", "mining shares" and "industrial,commercial or scientific equipment". In that connexion, it was mentionedfor instance that in the Republic of Korea there was no legal concept of"landed property" distinct from the concept of immovable property andthat the expression in the Korean language which was most similar tothe English term "partnership" did not correspond to the concept ofpartnership as used in the OECD Model Convention. Pending definition

35

of such terms by the Group of Experts the negotiating parties shouldendeavour to reach mutually acceptable definitions thereof.

It must be emphasized that the guidelines are not intended as asubstitute for negotiations between potential contracting parties. They arenot to be construed as binding provisions or as formal recommendationsof the United Nations or as representing in the give-and-take which char-acterizes the negotiating process, either the maximum or the minimumconcession that either potential contracting party should grant or demand.Indeed, in preparing its own negotiating strategy, a participating countrymay wish to review the provisions of bilateral double taxation treatiesentered into by the other country in order to survey concessions grantedin the past, departures from the guidelines herein propounded. and so on.,

Essentially, the guidelines are primarily intended to point the waytowards feasible approaches to the resolution of the issues involved thatboth potential contracting parties are likely to find acceptable. They aimat facilitating the negotiation of tax treaties by eliminating the need forelaborate analysis and protracted discussion of every issue ab originein the case of each treaty. They are designed to constitute a frameworkfor the negotiators, who can proceed with their work, secure in the know-ledge that the guidelines are the outcome of dispassionate in-depth ex-amination of the issues involved by top-level experts from both developedand developing countries who, by agreeing to become members of theGroup of Experts in their personal capacity, have committed themselvesto expressing entirely objective opinions based solely on technicalconsiderations.

Like the OECD Model Convention, the guidelines represent a com-promise between the source principle and the residence principle. How-ever, they give more weight to the source principle than does the OECDModel Convention which contains a more restrictive definition of a per-manent establishment and, in the areas of shipping profits, dividends.interest and royalties, relies more strongly on minimal taxation at sourceor sometimes exclusive taxation by the country of residence. As a correl-ative to the principle of taxation at source, the guidelines are predicatedon the premise of the recognition by the source country that taxation ofincome from foreign capital would take into account expenses allocableto the earning of the income so that such income would be taxed on anet basis, that the taxation would not be so high as to discourage invest-ment, and that it would take into account the appropriateness of a shar-ing of revenue with the country providing the capital.

In applying the guidelines, a country should bear in mind the factthat the relationship between treaties and domestic law may vary fromcountry to country and that it is important to take into account relation-ship between tax treaties and domestic law. Tax treaties affect the taxrules prevailing under the domestic tax laws of the Contracting States byproviding which Contracting State shall have jurisdiction to subject agiven income item to its national tax laws and under what conditionsand with what limitations it may do so. Consequently, countries wishingto enter into bilaterial tax treaty negotiations should analyse carefully the

1 Bilateral double taxation treaties are published by the United Nations on aregular basis in the series entitled International Tax Agreemets.

36

applicable provisions of their domestic tax laws in order to assess themodifications which would be introduced in their operation by the treaty.

It may also be noted that domestic tax laws in their turn exert aninfluence on the content of bilateral tax treaties. Thus, although therewas general agreement in OECD about the principles embodied in theOECD Model Convention and although most existing bilateral tax treatiesconform by and large with the latter, there are often substantial variationsfrom one treaty to another, due to differences in the domestic laws of thevarious Contracting States.

With regard to the possible influence of the work of the Group ofExperts, it would appear that it has already proved to be very useful. Ithas sustained and expanded interest in the problems of internationaldouble taxation and tax evasion and intensified the awareness of theneed to solve them within the framework of bilaterial tax treaties. Thereports of the Group of Experts are thought to have already contributedsignificantly to the strengthening of the negotiating skills of tax officialsof developing countries in their discussion with their counterparts fromdeveloped countries; in that connexion, the reports of the Group havebeen used as background documents and sometimes even as referencedocuments. Furthermore, the Group's reports have enabled tax officialsof developed countries to gain a better understanding of the developingcountries' view of what constitutes a more equitable assignment of taxjurisdiction between the source country and the country of residence inthe context of their desire to accelerate international movements of pri-vate capital and thus contribute to the development of the world economy.The reports have also contributed to an understanding by tax officialsof developing countries of the views put forward by experts from de-veloped countries and the need to strike a balance between the preserva-tion of the developing countries' taxing rights (source taxation) and themeasures required to attract foreign investment. In addition, the Grouphas constituted a forum which has enabled tax officials from both de-veloped and developing countries to exchange views on the problems andconstraints of international taxation and to work out common bases ofunderstanding which have found concrete expression in the guidelines.

It is of course very difficult, if not impossible, to prove the existenceof a clear-cut cause-and-effect relationship between the work of theGroup of Experts and the bilateral tax treaties between developing anddeveloped countries concluded since its inception. However, it may beof interest in this context to note that from the quantitative standpoint,well over 60 such treaties, constituting about one-third of the cumulativetotal of tax treaties between developed and developing countries havebeen concluded since the Group began its work. Of particular significanceis the fact that a number of such treaties have been negotiated andamended partly on the basis of the guidelines.

The wide dissemination of the latter is expected to create greaterawareness of the need to solve the problems of international double taxa-tion and tax evasion and avoidance arising between developing and de-veloped countries and between developing countries. It is hoped that theguidelines will contribute to the solution of those problems by fosteringa climate of informed understanding and co-operation as regards taxes

37

imposed across national borders and by exerting a catalytic effect leadingto the successful negotiation of a widening network of increasingly uni-form bilateral tax treaties. Such an evolution would be in accordancewith a wish expressed by the Group of Eminent Persons appointed bythe Secretary-General of the United Nations pursuant to Economic andSocial Council resolution 1721 (LIII) to study the role of multinationalcorporations and their impact on the process of development, especiallythat of the developing countries. In its report to the Secretary-Generalthe Group of Eminent Persons expressed the view that if, through thework of the Group of Experts on Tax Treaties, the provisions of bilateraltax treaties "could be standardized, with only a small number of clausesto be negotiated in particular cases, they would in fact amount to aninternational agreement on taxation which we consider to be the finalobjective". 2 The Group of Eminent Persons then recommended that "thebilateral treaties should be as uniform as possible so as to prepare the wayfor an international tax agreement".3

The Group stressed the importance of exchange of information bothto the administration of tax treaties and to the fight against tax evasionand avoidance. While the Group generally felt that a multilateral agree-ment on the exchange of information and mutual assistance in tax ad-ministration was premature, there was a general consensus that emphasison those matters was very important. In that regard the Group recognizedthe usefulness of a forum for sharing technical experiences in the fieldof tax administration. It was recognized that the establishment of sucha forum would not require a formal multilateral agreement. It was there-fore suggested that the United Nations Secretariat, in close co-operationwith competent intergovernmental organizations and tax administrationsin both developed and developing countries, should consider the possi-bility of undertaking preparatory work for such a project.

The guidelines are divided into chapters. Chapter I contains sug-gested texts concerning the scope of the treaty, while Chapter II definesterms used in bilateral tax treaties. Chapter III (taxation of income),Chapter IV (taxation of capital) and Chapter V (methods for eliminationof double taxation) constitute what may be regarded as the main sub-stantive segments of the guidelines. Chapter VI contains special pro-visions and Chapter VII final provisions. A detailed summary of theguidelines follows.

2 The Impact of Multinational Corporations on Development and on Inter-national Relations (United Nations publication, Sales No. E.74.II.A.5), chap. XI,p. 92.

31bid.

38

SUMMARY OF THE GUIDELINES

TITLE AND PREAMBLE OF THE TREATY

CHAPTER I

Scope of the Treaty

Guideline 1:Guideline 2:

GuidelineGuidelineGuideline

GuidelineGuidelineGuideline

GuidelineGuidelineGuidelineGuidelineGuidelineGuidelineGuidelineGuideline

3:4:5:

6:7:8:

9:10:11:12:13:14:15:16:

Guideline 17:Guideline 18:Guideline 19:

Guideline 20:Guideline 21:

Guideline 22:

Personal scope .......................Taxes covered .......................

CHAPTER 11Definitions

General definitions ............... .....R esident ........................ . ...Permanent establishment .................

CHAPTER IIITaxation of income

Income from immovable property......Business profits ........................Shipping, inland waterways transport and airtransport ...........................Associated enterprises ..................D ividends ....... ....................Interest ...............................R oyalties .............................Capital gains ..........................Independent personal services .............Dependent personal services .............Directors' fees and remuneration of top-levelm anagerial officials .....................Income earned by entertainers and athletesPensions ...........................Remuneration in respect of government servicesand social security payments ..............Payments received by students and apprenticesOther income ........................

CHAPTER IVTaxation of capital

Capital .............................

39

Page4142

434446

5253

5862626673798082

838485

868889

90

CHAPTER VMethods for elimination of double taxation

Guideline 23A:Guideline 23B:

Guideline 24:Guideline 25:Guideline 26:Guideline 27:

Guideline 28:Guideline 29:

Exemption method ....................Credit method .......................

CHAPTER VISpecial provisions

Non-discrimination ............ .......Mutual agreement procedure .............Exchange of information ................Diplomatic agents and consular officers ......

CHAPTER VIIFinal provisions

Entry into force ........................Termination ...........................Terminal clause ......................

40

Page9191

929598

101

102102102

TITLE OF THE TREATY

Treaty between (State A) and (State B) for the avoidance ofdouble taxation with respect to taxes on income and on capital.

PREAMBLE OF THE TREATY

[N.B.The Preamble of the Treaty shall be drafted in accordance with the

constitutional procedures of both Contracting States. The Group of Ex-perts observed that the references to capital in the following guidelineswere to be disregarded in the case of countries which have not deemed itnecessary to levy a tax on capital.]

CHAPTER I

SCOPE OF THE TREATY

A. Personal scope

Guideline I

The treaty shall apply to persons who are residents of one or both ofthe Contracting States.

ObservationsThe Group agreed to recommend as a suggested text for an article

in a bilateral tax treaty defining the personal scope of the treaty the textof article 1 of the OECD Model Convention. Consequently the whole ofthe commentary on the latter article is relevant to guideline 1.

B. Taxes covered'

Guideline 2

1. The treaty shall apply to taxes on income and on capital im-

'The references to capital are to be disregarded if it is not intended to includein the treaty an article on the taxation of capital (see guideline 22).

41

posed on behalf of a Contracting State or of its political subdivisions orlocal authorities, irrespective of the manner in which they are levied.

2. All taxes imposed on total income, on total capital, or on ele-ments of income or of capital, including taxes on gains from the aliena-tion of movable or immovable property, taxes on the total amounts ofwages or salaries paid by enterprises, as well as taxes on capital apprecia-tion shall be regarded as taxes on income and on capital.

3. The existing taxes to which the treaty shall apply are in par-ticular:

(a) (in State A ): ..... ......... ... ..... ..........(b) (in State B ): .............. ... ....... ...........

4. The treaty shall apply also to any identical or substantially simi-lar taxes which are imposed after the date of signature of the treaty inaddition to, or in place of, the existing taxes. At the end of each year,the competent authorities of the Contracting States shall notify each otherof changes which have been made in their respective taxation laws.

Observations

The same income or capital may be subject in the same country tovarious taxes-either taxes which differ in nature, or taxes of the samenature levied by different political subdivisions or local authorities.Hence, double taxation cannot be wholly avoided unless the methods forthe relief of double taxation applied in each Contracting State take intoaccount all the taxes to which such income or capital is subject. Conse-quently, the terminology and nomenclature relating to the taxes coveredby a treaty must be clear, precise, and as comprehensive as possible. Asnoted by the OECD Committee on Fiscal Affairs, this is necessary in orderto "ensure identification of the Contracting States' taxes covered by theConvention, to widen as much as possible the field of application of theConvention by including as far as possible, and in harmony with thedomestic laws of the Contracting States, the taxes imposed by their polit-ical subdivisions or local authorities, and to avoid the necessity of con-cluding a new convention whenever the Contracting States' domestic lawsare modified, by means of the periodical exchange of lists and through aprocedure for mutual consultation". 2

The Group agreed to recommend as a suggested text for an articlein a bilateral tax treaty defining the taxes to be covered by the treatythe text of article 2 of the OECD Model Convention. Consequently, thewhole of the commentary on the latter article is relevant to guideline 2.

2 Organization for Economic Co-operation and Development, Model DoubleTaxation Convention on Income and on Capital: Report of the Committee on FiscalAffairs (Paris, 1977), p. 49.

42

CHAPTER 11

DEFINITIONS

A. General definitions

Guideline 3

1. For the purposes of the treaty, unless the context otherwiserequires:

(a) the term "person" includes an individual, a company and anyother body of persons;

(b) the term "company" means any body corporate or any entitywhich is treated as a body corporate for tax purposes;

(c) the terms "enterprise of a Contracting State" and "enterpriseof the other Contracting State" mean respectively an enterprise carriedon by a resident of a Contracting State and an enterprise carried on bya resident of the other Contracting State;

(d) the term "international traffic" means any transport by a shipor aircraft operated by an enterprise which has its place of effective man-agement in a Contracting State, except when the ship or aircraft is op-erated solely between places in the other Contracting State;

(e) the term "competent authority" means:(i) (in State A):. ........ .

(ii) (in State B): .2. As regards the application of the treaty by a Contracting State

any term not defined therein shall, unless the context otherwise requires,have the meaning which it has under the law of that State concerning thetaxes to which the treaty applies.

ObservationsA number of general definitions are normally necessary for the un-

derstanding and application of a treaty, although terms relating to morespecialized concepts are usually defined or interpreted in special pro-visions. On the other hand, there are terms whose definitions are notincluded in the treaty but are left to bilateral negotiations by the partiesto the treaty. The OECD Model Convention groups in its article 3 a num-ber of general definitions required for the interpretation of the termsused in that instrument. These terms are "person", "company", "enter-prise of a Contracting State" and "international traffic". Article 3 leavesspace for the designation of the "competent authority" of each Contract-ing State. The terms "resident" and "permanent establishment" are de-fined in articles 4 and 5 respectively, while the interpretation of certainterms used in the articles on special categories of income (e.g. immovableproperty, dividends) is clarified in the articles concerned. The parties toa treaty are left free to agree bilaterally on a definition of the terms "aContracting State" and "the other Contracting State". They are also freeto include in the possible definition of a Contracting State a reference tocontinental shelves.

43

The Group of Experts considered that the approach taken in article3 of the OECD Model Convention was satisfactory and therefore agreedto recommend as a suggested text for an article defining terms used in abilateral tax treaty the text of article 3 of the OECD Model Convention.Consequently, the whole of the commentary on the latter article is rele-vant to guideline 3. As a corollary of its adoption of the OECD approach,the Group decided to include suggested definitions of the terms "resident"and "permanent establishment" in special guidelines and to leave thedefinitions of the "a Contracting State" and "the other Contracting State"to be worked out in bilateral negotiations by the parties to the treaty.The Group noted that the latter might wish to include a reference tocontinental shelves in the possible definition of "a Contracting State"and were free to include a definition of any other term they deemedimportant.

B. Resident

Guideline 4

1. For the purposes of the treaty, the term "resident of a Con-tracting State" means any person who, under the laws of that State, isliable to tax therein by reason of his domicile, residence, place of man-agement or any other criterion of a similar nature.

2. Where by reason of the provisions of paragraph I an individualis a resident of both Contracting States, then his status shall be deter-mined as follows:

(a) He shall be deemed to be a resident of the State in which hehas a permanent home available to him; if he has a permanent home avail-able to him in both States, he shall be deemed to be a resident of theState with which his personal and economic relations are closer (centre ofvital interests);

(b) If the State in which he has his centre of vital interests cannotbe determined, or if he has not a permanent home available to him ineither State, he shall be deemed to be a resident of the State in which hehas a habitual abode;

(c) If he has a habitual abode in both States or in neither of them,he shall be deemed to be a resident of the State of which he is a national;

(d) If he is a national of both States or of neither of them, thecompetent authorities of the Contracting States shall settle the questionby mutual agreement.

3. Where by reason of the provisions of paragraph 1 a personother than an individual is a resident of both Contracting States, then itshall be deemed to be a resident of the State in which its place of effectivemanagement is situated.

ObservationsAccording to the OECD Committee on Fiscal Affairs, the concept

of "resident of a Contracting State" has various functions and is of im-portance in three cases:

In determining a treaty's personal scope of application;

44

In solving cases where double taxation arises in consequenceof double residence;

In solving cases where double taxation arises as a consequenceof taxation in the country of residence and the country of sourceor situs.3

Clearly, it is highly desirable that bilateral treaties should contain adefinition of the concept of residence that is acceptable to both Contract-ing States. The internal law definition of residence of those States willremain applicable unless there is a conflict between those laws with theresult that both States claim a person as a resident. In that case the per-son's residence will be determined according to the treaty definition.

The OECD Model Convention, article 4 of which is intended todefine the meaning of the term "resident of a Contracting State" and tosolve cases of double residence, makes referral to domestic laws thepreference criterion to be used for determining the residence of individ-uals and bodies corporate. However, the article also lists in decreasingorder of relevance a number of subsidiary criteria to be applied whenan individual is a resident of both Contracting States and the precedingcriteria do not provide a clear-cut determination of his status as regardsresidence. If none of these criteria suffices to determine the status of anindividual as regards residence, the article provides that the questionshall be settled by the competent authorities of the Contracting States bymutual agreement. In the case of bodies corporate the article provides,in paragraph 3, that their status as regards residence shall be determinedby a single criterion, namely, their "place of effective management".

The latter term is used in several provisions of the OECD ModelConvention, as is the term "place of management". Neither term is de-fined explicitly in the Convention itself or in the commentary thereon,nor is it made clear whether the two terms are to be construed as havingthe same meaning or two different meanings. However, the commentaryon article 4, paragraph 3, provides an indication of the way in which theterm "place of effective management" might be interpreted. The com-mentary notes that in the case of conventions concluded by the UnitedKingdom which provide that a company shall be regarded as resident inthe State in which "its business is managed and controlled", it has beenmade clear, on the United Kingdom side, that this expression means the"effective management" of the enterprise. It may therefore be inferredthat in the OECD Model Convention the term "place of effective man-agement" is to be interpreted as meaning the place where the businessof a body corporate is managed and controlled, that is, for example,where the business has offices in which the regular managerial activitiesare carried out on a permanent basis.

The Group of Experts felt that the definition of the term "residentof a Contracting State" provided in article 4 of the OECD Model Con-vention and the criteria set forth therein for determining status as regardsresidence in various situations, constituted an acceptable means of solv-ing cases of double taxation. The Group therefore agreed to recommendas a suggested text for an article in a bilateral tax treaty defining the term

- Ibid., p. 54.

45

"resident" the text of article 4 of the OECD Model Convention, providedthat the second sentence of paragraph 1 of that article was deleted. Thatsentence states: "But this term [resident] does not include any personwho is liable to tax in that State in respect only of income from sourcesin that State or capital situated therein." The Group was of the view thatalthough some countries might wish to include that sentence in bilateraltreaties, attention should be called to the fact that in some cases the sen-tence would be inappropriate for inclusion in such treaties. If one of theContracting States taxes solely income from domestic sources, and notincome from foreign sources, the inclusion of that sentence would resultin all residents of that country being characterized as non-residents forthe purpose of the bilateral tax treaty and as a result being deprived of itsbenefits. The Group therefore considered it inappropriate to include sucha sentence in guideline 4.

Consequently, the last two sentences of paragraph 8 of the OECDcommentary on article 4 do not apply to guideline 4 but the rest of thecommentary is relevant to that guideline.

C. Permanent establishment

Guideline 5

1. For the purposes of the treaty, the term "permanent establish-ment" means a fixed place of business through which the business of anenterprise is wholly or partly carried on.

2. The term "permanent establishment" includes especially:(a) A place of management;(b) A branch;(c) An office;(d) A factory;(e) A workshop; and(f) A mine, an oil or gas well, a quarry or any other place of ex-

traction of natural resources.3. The term "permanent establishment" likewise encompasses:(a) A building site or construction or assembly project or super-

visory activities in connexion therewith, where such site, project or ac-tivity continues for a period of more than six months;

(b) The furnishing of services, including consultancy services, byan enterprise through employees or other personnel, where activities ofthat nature continue (for the same or a connected project) within thecountry for a period or periods aggregating more than six months withinany 12-month period.

4. Notwithstanding the preceding provisions of this guideline, theterm "permanent establishment" shall be deemed not to include:

(a) The use of facilities solely for the purpose of storage or displayof goods or merchandise belonging to the enterprise;

(b) The maintenance of a stock of goods or merchandise belong-ing to the enterprise solely for the purpose of storage or display;

46

(c) The maintenance of a stock of goods or merchandise belong-ing to the enterprise solely for the purpose of processing by anotherenterprise;

(d) The maintenance of a fixed place of business solely for thepurpose of purchasing goods or merchandise or of collecting informa-tion, for the enterprise;

(e) The maintenance of a fixed place of business solely for thepurpose of carrying on, for the enterprise, any other activity of a pre-paratory or auxiliary character.

5. Notwithstanding the provisions of paragraphs 1 and 2, where aperson other than an agent of an independent status to whom paragraph7 applies is acting in a Contracting State on behalf of an enterprise ofthe other Contracting State, that enterprise shall be deemed to have apermanent establishment in the first-mentioned State if the person:

(a) Has and habitually exercises in that State an authority to con-clude contracts on behalf of the enterprise, unless his activities are limitedto the purchase of goods or merchandise for that enterprise; or

(b) Has no such authority, but habitually maintains in the first-mentioned State a stock of goods or merchandise from which he regularlydelivers goods or merchandise on behalf of the enterprise.

6. Notwithstanding the preceding provisions of this guideline, aninsurance enterprise of a Contracting State shall, except in regard to re-insurance, be deemed to have a permanent establishment in the otherState if it collects premiums in the territory of that State or insures riskssituated therein through an employee or through a representative who isnot an agent of independent status within the meaning of the nextparagraph.

7. An enterprise of a Contracting State shall not be deemed tohave a permanent establishment in the other Contracting State merely be-cause it carries on business in that other State through a broker, generalcommission agent or any other agent of an independent status, providedthat such persons are acting in the ordinary course of their business. How-ever, when the activities of such an agent are devoted wholly or almostwholly on behalf of that enterprise, he will not be considered an agent ofan independent status within the meaning of this paragraph.

8. The fact that a company which is a resident of a ContractingState controls or is controlled by a company which is a resident of theother Contracting State, or which carries on business in that other State(whether through a permanent establishment or otherwise) shall not ofitself constitute either company a permanent establishment of the other.

ObservationsThe concept of permanent establishment is used in bilateral tax

treaties principally for the purpose of determining the right of a Con-tracting State to tax the profits of an enterprise of the other ContractingState. Such treaties, which are generally patterned after the OECD ModelConvention, provide that an enterprise of one Contracting State shall betaxable in the other only if it maintains a permanent establishment in thelatter State and only to the extent that the profits earned by the enterprise

47

in that State are attributable to that permanent establishment. The per-manent establishment principle frees from taxation at the source not onlyoccasional business transactions, but also continuing trading activitieswhich do not entail the presence of a permanent establishment in thesource country. The term "permanent establishment" was already usedin the 1928 Model Conventions of the League of Nations. The OECDModel Convention reaffirms the concept of permanent establishment andsupplements it by introducing the new concept of a "fixed base", to beused in the case of professional services or other activities of an inde-pendent character.

Concerning the application of the OECD definition of permanentestablishment to tax treaties with developing countries, a 1965 report ofthe OECD Fiscal Committee sets forth the following considerations:

"In the tax treaties between capital exporting countries and inthe OECD draft, the problem posed by differences in the rules ofsource or in the allocation of income is solved in part by tax exemp-tion based upon the so-called permanent establishment principle.Under this rule, income derived by an enterprise of one countryfrom activities conducted in another country is not subject to tax inthe other country unless conducted through a permanent establish-ment there. This does not dispose of the problem created by differ-ent rules of source, except in those cases where an enterprise of onecountry is engaged in business activities in the other in such a formas not to constitute a permanent establishment.

"In general, trade relations between developing and industrial-ized countries involve the flow of natural resource products fromthe developing to the industrialized country and of processed andmanufactured goods from the industrialized to the developing coun-try. Enterprises in developing countries do not engage in significantbusiness activity in industrialized countries. Given these trading re-lationships, it would seem that the permanent establishment principlewould favour the industrialized countries. However, with increasingindustrialization in developing countries, sales and buying activityin developed countries may be facilitated by the permanent estab-lishment concept. It may also make it possible for firms in capitalexporting countries to maintain repair parts, supplies, etc., in a de-veloping country which may otherwise not be feasible. Accordingly,there is a place for the permanent establishment principle in tax con-ventions with developing countries, although it may be necessary toadapt it to a certain extent to the differing relations between devel-oping and industrialized countries.

"The need for supplementing the permanent establishmentprinciple with rules for allocating income seems all the greater in thatthe permanent establishment test as such does not dispose of thekind of source problems to which attention has been called above.Developing countries tend to adopt rules which will maximise theincome subject to their tax in view of their need for revenue andtheir limited resources, and this may well be a major source ofdouble taxation. The adoption of rules of source, with appropriateformulae for allocating income in various types of situations, may

48

be more important in relations between developing and industrializedcountries than between industrialized countries."4

The Group of Experts, while accepting the concept of permanentestablishment as contained in the OECD Model Convention sought toadapt it to a certain extent to the requirements of relations between de-veloping and developed countries. It therefore agreed to recommend asa suggested text for an article in a bilateral tax treaty defining the term"permanent establishment" a text incorporating a number of provisionsof article 5 of the OECD Model Convention (either unchanged or sub-stantially amended) and some new provisions. The commentary on article5 of the OECD Model Convention is therefore relevant mutatis mutandisto guideline 5.

Paragraph 1 of guideline 5 reproduces article 5, paragraph 1, of theOECD Model Convention.

Paragraph 2 of the guideline reproduces the whole of paragraph 2of article 5 of the OECD Model Convention.

Paragraph 3 of the guideline covers a broader range of activitiesthan article 5, paragraph 3, of the Convention. In subparagraph 3 (a) theterm "installation project" used in the Convention is replaced by theterm "assembly project" which, unlike the OECD article, covers "super-visory activities" in connexion with "a building site or construction orassembly project". Moreover, while article 5 states that "a building site orconstruction or installation project constitutes a permanent establishmentonly if it lasts more than twelve months", guideline 5 reduces the dura-tion of that period to six months. In special cases, the six-month periodin paragraph 3, subparagraphs (a) and (b) of guideline 5 could be reducedto a period of not less than three months in bilateral negotiations.

It may be noted that there was substantial support within the Groupof Experts, especially among members from developing countries, for amore elaborate version of subparagraph 3 (a) which would have read asfollows:

"The term permanent establishment should likewise encompassa building site or construction or assembly project or supervisoryactivities in connexion therewith, where such site, project or activity,being incidental to the sale of machinery or equipment, continuesfor a period not exceeding six months and the charges payable forthe project or activity exceed 10 per cent of the sale price of themachinery or equipment."

Other members, however, felt that such a provision would not constitutean adequate solution, particularly if the machinery was delivered by anenterprise other than the one doing the construction work.

Paragraph 3 of the guideline contains a new subparagraph (b) deal-ing with the furnishing of services, including consultancy services whichare not covered specifically in the OECD Model Convention in con-nexion with the concept of permanent establishment. The Group felt thatmanagement and consultancy services should be covered in the guidelinesbecause the provision of such services in developing countries by cor-porations of industrialized countries often involves very large sums of

4Organization for Economic Co-operation and Development, Fiscal Incentivesfor Private Investment in Developing Countries: Report of the Fiscal Committee(Paris, 1965), paras. 172-174.

49

money. The Group was of the opinion that profits from such servicesshould be taxed by developing countries in certain circumstances.

Concerning the time-limit established in paragraph 3, subparagraphs(a) and (b), of guideline 5, some members of the Group from developingcountries said that they would have preferred to remove the time-limitaltogether for two main reasons: first, because construction, assembly andsimilar activities could as a result of modern technology be of very shortduration and still result in a considerable profit for the enterprise carryingon those activities; and, secondly, because the period during which theforeign personnel involved in the activities remained in the source coun-try was irrelevant to the definition of the right of developing countriesto tax the corresponding income. Other members from developing coun-tries felt that any time-limit should have been removed because such alimitation was apt to be used by enterprises of capital exporting countriesto evade taxation in the source country. The view was expressed thatthere was no reason why a construction project should not be treated inthe same manner as artistes, athletes and public entertainers covered byarticle 17 of the OECD Model Convention, who are taxed at the placewhere their activities are performed irrespective of the duration of thoseactivities. Members from developed countries observed that the Group'stask was to work out guidelines for treaty provisions that would promoteinternational trade and development, and that the idea behind the time-limit was that business enterprises of one Contracting State should beencouraged to initiate preparatory or ancillary operations in the otherContracting State without becoming immediately subject to the tax of thelatter State, so as to facilitate a more permanent and larger commitmentat a later stage.

Most members agreed that monetary limitations, if set by analogywith those applied to services of individuals in a number of tax treaties,would be meaningless in the area of the corporate services here discussed,while other members were opposed to any monetary limitations. On theother hand, some members felt that the physical presence of representa-tives of a foreign corporation in the source country for a minimum period,such as six months, would be a reasonable limitation which would, as apractical matter, cover most of the important situations and would pre-clude administrative difficulties in the case of merely sporadic activities.

Some members from developed countries thought that the time-limit approach would be an acceptable solution if the words "for thesame or a connected project" were inserted after the word "continue",since they thought it desirable to add together unrelated projects in viewof the uncertainty which that step involved and the undesirable distinc-tion it created between an enterprise with, for example, one project ofthree months' duration and another with two projects, each of threemonths' duration, one following the other. In this respect, other membersfound that the injection of a "project" limitation would be either too easyto manipulate or too narrow in that it might preclude taxation in the caseof a continuous number of separate projects, each of four or five months'duration.

There was general agreement that only profits from services attribut-able to a permanent establishment in the source country should be taxableby it.

50

Paragraph 4 of guideline 5 reproduces article 5, paragraph 4, of theOECD Model Convention, with three substantive amendments, namely,the deletion of the term "delivery" in subparagraphs (a) and (b) and thedeletion of subparagraph (f). The deletion of the term "delivery" wasagreed on after members from developing countries pointed out that thepresence of a stock of goods for prompt delivery facilitated the sales ofthe product and thereby the earning of profit in the host country by theenterprise having the facility. There was a continuous connexion andhence the existence of such a supply of goods, they argued, should con-stitute a permanent establishment, leaving as a separate matter the deter-mination of the proper amount of income attributable to the permanentestablishment. The Group felt that it would be preferable to leave openfor bilateral negotiations the question of whether cases involving deliv-eries made from stocks of goods should be included in or excluded fromthe definition of permanent establishment. Some members from developedcountries pointed out that, since in the normal case only a small amountof income would be allocated if the only activity were that described inthe proposed clause, it would not serve any purpose to make the change.

Paragraph 5 of guideline 5 departs substantially from and is con-siderably broader in scope than article 5, paragraph 5 of the OECDModel Convention, which the Group considered to be too narrow inscope because it states that only one type of agent should be deemed tocreate an establishment of a non-resident enterprise, exposing it to taxa-tion in the source country. Some members from developing countriespointed out that a narrow formula might encourage tax evasion by per-mitting an agent who was in fact dependent to represent himself as actingon his own behalf. It was the understanding of the Group that the phrase"authority to conclude contracts on behalf of" in subparagraph 5 (a) ofguideline .5 means that the agent has legal authority to bind the enter-prise for business purposes and not only for administrative purposes (e.g.,conclusion of lease or electricity and manpower contracts).

Paragraph 6 of the guideline does not correspond to any provisionof the OECD Model Convention. It was included because it was the com-mon feeling of the Group that the OECD definition of permanent estab-lishment was not adequate to deal with certain aspects of the insurancebusiness. Members from developing countries had previously pointed outthat if an insurance agent was independent, the profits would not be tax-able in accordance with the provisions suggested in paragraph 7 of guide-line 5 (based on article 5, paragraph 6, of the OECD Model Convention);and if the agent was dependent, no tax could be imposed because insur-ance agents normally had no authority to conclude contracts as would berequired under the provisions suggested in paragraph 5 (a) of guideline 5(based on article 5, paragraph 5, of the OECD Model Convention). Thosemembers had expressed the view that taxation of insurance profits in thecountry where the premiums were being paid was desirable and shouldtake place independently of the status of the agent. They therefore sug-gested that the guidelines should include, a special provision relating toinsurance business.

Once agreement had been reached on the principle of including aspecial provision on insurance, the discussion in the Group focused mainlyon cases involving representation through "an independent agent". Mem-

51

bers from developing countries felt it would be desirable to provide that apermanent establishment existed in such cases because of the nature ofthe insurance business, the fact that the risks were situated within thecountry claiming tax jurisdiction, and the facility with which personscould, on a part-time basis, represent insurance companies on the basisof an "independent status", making it difficult to distinguish betweendependent and independent insurance agents. Members from developedcountries, on the other hand, stressed that in cases involving independentagents, insurance business should not be treated differently from suchactivities as the sale of tangible commodities. Those members also drewattention to the difficulties involved in ascertaining the total amount ofbusiness done when the insurance was handled by a number of indepen-dent agents within the same country. In view of the difference in ap-proach, the Group agreed that the case of representation through in-dependent agents should be left to bilateral negotiations, which could takeaccount of the methods used to sell insurance and other features of theinsurance business in the countries concerned.

The first sentence of paragraph 7 of guideline 5 reproduces article 5,paragraph 6, of the OECD Model Convention in its entirety, with a fewminor drafting changes. The second sentence of paragraph 7 constitutesa new provision whose inclusion stemmed from a proposal by membersfrom developing countries to broaden the scope of the definition of apermanent establishment by treating as a dependent agent an agent whohabitually secures orders exclusively or almost exclusively for an enter-prise of the other Contracting State or an affiliated enterprise. In supportof that proposal it had been argued that when an agent, although actingin an independent capacity, acted for only one enterprise and devoted histime and activity wholly or almost wholly on behalf of that enterprise, helost his independent status.

It was stated that the confinement of the activities of an agent whollyor almost wholly to those undertaken on behalf of one enterprise must bepursuant to an agreement with that enterprise. Some members from devel-oping countries felt that the existence of such an agreement should notbe a requirement for the application of the amendment replacing article5, paragraph 5, of the OECD Model Convention for in practice it wouldannul it.

Paragraph 8 of guideline 5 reproduces article 5, paragraph 7, of theOECD Model Convention.

CHAPTER III

TAXATION OF INCOME

A. Income from immovable property

Guideline 61. Income derived by a resident of a Contracting State from im-

movable property (including income from agriculture or forestry) situatedin the other Contracting State may be taxed in that other State.

52

2. The term "immovable property" shall have the meaning whichit has under the law of the Contracting State in which the property inquestion is situated. The term shall in any case include property accessoryto immovable property, livestock and equipment used in agriculture andforestry, rights to which the provisions of general law respecting landedproperty apply, usufruct of immovable property and rights to variableor fixed payments as consideration for the working of, or the right towork, mineral deposits, sources and other natural resources; ships, boatsand aircraft shall not be regarded as immovable property.

3. The provisions of paragraph 1 shall also apply to incomederived from the direct use, letting or use in any other form of immovableproperty.

4. The provisions of paragraphs 1 and 3 shall also apply to theincome from immovable property of an enterprise and to income fromimmovable property used for the performance of independent personalservices.

ObservationsThe right to tax income from immovable property including the

income from agriculture and forestry is given to the country in which suchproperty is situated (source country) under article 6 of the OECD ModelConvention. The principle of taxing income from immovable property atsource was upheld by the Group of Experts, which agreed to recommendas a suggested text for an article in a bilateral tax treaty relating to thetaxation of income from immovable property the text of article 6 of theOECD Model Convention. Consequently the whole of the commentaryon the latter article is relevant to guideline 6.

The Group observed that in keeping with other situations of taxationat source, the taxation of the income from immovable property shouldhave as its appropriate objective the taxation of profits rather than grossincome. Account should therefore be taken of the expenses involved inearning income from real property or from agriculture or forestry. Thatobjective, however, should not preclude the use of a withholding tax onrents from real property, based on gross income; in such cases the rateshould take into account the fact that expenses were involved in theirearning. On the other hand the Group felt that it would be equally satis-factory if, where a withholding tax on gross rents is used, the owner ofthe real property could elect to have the income from the property taxedon a net basis under the regular income tax. According to the Group, theguideline is not intended to preclude a country which taxes income fromagriculture or other immovable property on an estimated or similar basisfrom utilizing that method.

B. Business profits

Guideline 7

1. The profits of an enterprise of a Contracting State shall betaxable only in that State unless the enterprise carries on business in theother Contracting State through a permanent establishment situatedtherein. If the enterprise carries on business as aforesaid, the profits of

53

the enterprise may be taxed in the other State but only so much of themas is attributable to (a) that permanent establishment; (b) sales in thatother State of goods or merchandise of the same or similar kind as thosesold through that permanent establishment; or (c) other business activitiescarried on in that other State of the same or similar kind as those effectedthrough that permanent establishment.

2. Subject to the provisions of paragraph 3, where an enterpriseof a Contracting State carries on business in the other Contracting Statethrough a permanent establishment situated therein, there shall in eachContracting State be attributed to that permanent establishment the prof-its which it might be expected to make if it were a distinct and separateenterprise engaged in the same or similar activities under the same orsimilar conditions and dealing wholly independently with the enterpriseof which it is a permanent establishment.

3. In the determination of the profits of a permanent establish-ment, there shall be allowed as deductions expenses which are incurredfor the purposes of the business of the permanent establishment includingexecutive and general administrative expenses so incurred, whether inthe State in which the permanent establishment is situated or elsewhere.However, no such deduction shall be allowed in respect of amounts, ifany, paid (otherwise than towards reimbursement of actual expenses) bythe permanent establishment to the head office of the enterprise or anyof its other offices, by way of royalties, fees or other similar payments inreturn for the use of patents or other rights, or by way of commission, forspecific services performed or for management, or, except in the case of abanking enterprise, by way of interest on moneys lent to the permanentestablishment. Likewise, no account shall be taken in the determinationof the profits of a permanent establishment, for amounts charged (other-wise than towards reimbursement of actual expenses), by the permanentestablishment to the head office of the enterprise or any of its other offices,by way of royalties, fees or other similar payments in return for the useof patents or other rights, or by way of commission for specific servicesperformed or for management, or, except in the case of a banking enter-prise, by way of interest on moneys lent to the head office of the enterpriseor any of its other offices.

4. In so far as it has been customary in a Contracting State todetermine the profits to be attributed to a permanent establishment on thebasis of an apportionment of the total profits of the enterprise to its var-ious parts, nothing in paragraph 2 shall preclude that Contracting Statefrom determining the profits to be taxed by such an apportionment asmay be customary; the method of apportionment shall, however, be suchthat the result will be in accordance With the principles contained in thisguideline.

5. For the purposes of the preceding paragraphs, the profits to beattributed to the permanent establishment shall be determined by thesame method year by year unless there is good and sufficient reason tothe contrary.

6. Where profits include items of income which are dealt withseparately in other guidelines, then the provisions of those guidelinesshall not be affected by the provision of this guideline.

54

[N.B.The question of whether profits should be attributed to a permanent

establishment by reason of the mere purchase by that permanent estab-lishment of goods and merchandise for the enterprise was not resolved.The Group agreed that it should be settled in bilateral negotiations.]

Observations

The most relevant question in international tax practice concerningbusiness profits relates to the facts which make an enterprise liable totaxation on its profits in a foreign country. There is general acceptanceof the so-called "arm's length" rule embodied in the OECD Draft ModelConvention. According to this rule, the profits attributable to a perma-nent establishment are those which would be earned by the establishmentif it were a wholly independent entity dealing with its head office as if itwere a distinct and separate enterprise operating under conditions andselling at prices prevailing in the regular market. The profits so attribut-able are normally the profits shown on the books of the establishment.Nevertheless, this rule permits the authorities of the country in which thepermanent establishment is located to rectify the accounts of the enter-prise, so as to reflect properly income which the establishment wouldhave earned if it were an independent enterprise dealing with its headoffice at arm's length.

The application of the arm's length rule is particularly important inconnexion with the difficult and complex problem of the deductions to beallowed to the permanent establishment. It is also generally accepted thatin calculating the profits of a permanent establishment, allowance shouldbe made for expenses, wherever incurred, for the purposes of the businessof the permanent establishment, including executive and general adminis-trative expenses. Apart from what may be regarded as ordinary expenses,there are some classes of expenditures that give rise to special problems.These include interest and royalties etc. paid by the permanent estab-lishment to its head office in return for money loaned or patent rightslicensed by the latter to the permanent establishment. They further includecommissions (except for the reimbursement of actual expenses) for spe-cific services or for the exercise of management services by the enterprisefor the benefit of the establishment. In these cases, it is considered that thepayments should not be allowed as deductions in computing the profitsof the permanent establishment. Conversely, such payments made to apermanent establishment by the head office should be excluded from theprofits of the permanent establishment. On the other hand, an allocableshare of such payments, e.g., interest and royalties, paid by the enterpriseto third parties should be allowed.

Although according to the OECD Model Convention only profitsattributable to the permanent establishment should be taxable in thesource country, in some cases the "attribution principle" has been am-plified by the so-called "force of attraction" rule, which permits the enter-prise, once it carries out business through a permanent establishment inthe source country, to be taxed on business profits in that country arisingfrom transactions outside the permanent establishment. Furthermore,non-business income of the enterprise may likewise be attracted into thetaxable income of the permanent establishment.

55

In the light of the foregoing considerations, the Group of Expertsagreed to recommend as a suggested text for an article in a bilateral taxtreaty relating to the taxation of business profits a text incorporating anumber of provisions of article 7 of the OECD Model Convention, eitherunchanged or substantially amended and some new provisions. The cont-mentary on article 7 of the OECD Model Convention is therefore relevantmutatis mutandis to guideline 7.

Paragraph 1 of guideline 7 reproduces article 7, paragraph 1, of theOECD Model Convention, with the addition of the provisions containedin clauses (b) and (c). In the discussion preceding the adoption of para-graph 1 of guideline 7 several members from developing countries ex-pressed support for the "force of attraction" rule, although they wouldlimit the application of that rule to business profits covered by article 7 ofthe OECD Model Convention and not extend it to income from capital(dividends, interests and royalties) covered by other treaty provisions.The members supporting the application of the "force of attraction" rulealso indicated that neither sales through independent commission agentsnor purchase activities would become taxable to the principal under thatrule. Some members from developed countries pointed out that the "forceof attraction" rule had been found unsatisfactory and abandoned in re-cent tax treaties concluded by them because of the undesirability of taxingincome from an activity that was totally unrelated to the establishmentand that was in itself not extensive enough to constitute a permanentestablishment. They also stressed the uncertainty that such an approachwould create for taxpayers. Members from developing countries pointedout that the proposed "force of attraction" approach did remove someadministrative problems in that it made it unnecessary to determinewhether particular activities were or were not related to the permanentestablishment or the income involved attributable to it. That was the caseespecially with respect to transactions conducted directly by the homeoffice within the country, but similar in nature to those conducted by thepermanent establishment. However, after discussion, there was a pro-posal to limit the "force of attraction" rule, so that it would apply to salesof goods or merchandise and other business activities in the followingmanner: if an enterprise has a permanent establishment in the other Con-tracting State for the purpose of selling goods or merchandise, sales ofthe same or a similar kind may be taxed in that State even if they are notconducted through the permanent establishment; a similar rule will applyif the permanent establishment is used for other business activities andthe same or similar activities are performed without any connexion withthe permanent establishment.

Clauses (b) and (c) were deemed entirely acceptable by the membersfrom developing countries and a few members from developed countries.Other members from developed countries said that they could acceptclauses (b) and (c) if those clauses were understood not to extend to saleseffected by agents of an independent status. Others believed that such anexception would be less acceptable than either the original OECD pro-vision or that provision amended by clauses (b) and (c). In effect, if thatexception were admitted taxation in the host country would depend uponwhether an independent commission agent or broker was involved, whichthey felt would not be a logical distinction and would, moreover, lend

56

itself to artificial sales arrangements. A few members from developedcountries thought that the addition of clauses (b) and (c) were undesirableand preferred the OECD text.

Paragraph 2 of guideline 7 reproduces article 7, paragraph 2, of theOECD Model Convention.

In the discussion relating to that paragraph, a member from a devel-oped country pointed out that his country was having some problemswith inconsistent determinations of the profits properly attributable toa permanent establishment, especially with regard to "turn-key" con-tracts. It was recalled that under a turn-key contract a contractor agreedto construct a factory or similar facility and make it ready for operation.When the facility was ready for operation, it was handed over to the pur-chaser, who could then begin operations. The international tax problemsoccurred when the facility was to be constructed in one country by a con-tractor resident in another country. The actual construction activitiescarried on in one country clearly constituted a permanent establishmentwithin that country if of sufficiently long duration. Turn-key contracts,however, were often concluded before the creation of the permanentestablishment and involved many components other than normal con-struction activities. They also included the purchase of capital goods, theperformance of architectural and engineering services and the provisionof technical assistance. Those latter items, it was explained, were some-times completed before construction activities actually started (and hence,before the creation of a permanent establishment at the construction site)and often outside the country in which the construction site/permanentestablishment was situated.

The question thus arose as to how much of the total profits of theturn-key contract was properly attributable to the permanent establish-ment and thus taxable in the country in which it was situated. A memberfrom a developed country said that he knew of instances in which coun-tries had sought to attribute the entire profits of the contract to the per-manent establishment. It was his view, however, that only the profitsattributable to activities carried on by the permanent establishment shouldbe taxed in the country in which the permanent establishment was situ-ated, unless the profits included items of income dealt with separatelyin other articles of the Convention and were taxable in that countryaccordingly.

The Group recognized that the problem described above was a com-plex and potentially controversial one involving many interrelated issues,such as source of income rules and the definitions of permanent estab-lishment and profits of an enterprise. The Group therefore decided todefer discussion of that problem until it had been studied more fully.

The first sentence of paragraph 3 of guideline 7 reproduces theentire text of article 7, paragraph 3, of the OECD Model Convention.The rest of the paragraph consists of new provisions formulated by theGroup of Experts. These provisions stemmed from a proposal by mem-bers from developing countries who felt that it would be helpful toinclude all necessary definitions and clarifications in the text of the guide-line, especially with a view to assisting developing countries not repre-sented in the Group. Some of those members also felt that provisionsprohibiting the deduction of certain expenses should be included in thetext of a bilateral tax treaty to make it clear that taxpayers were fully

57

informed about their fiscal obligations. In the course of the discussion itwas pointed out that additions to the OECD text would ensure that thepermanent establishment would be able to deduct interest, royalties andother expenses incurred by the head office on behalf of the establishment.The Group agreed that if billings by the head office included its full costs,both direct and indirect, then there should not be a further allocation ofthe executive and administrative expenses of the head office, since thatwould produce a duplication of such charges on the transfer between thehead office and the permanent establishment. It was pointed out that it wasimportant to determine how the price was fixed and what elements of costit included. Where an international wholesale price was used, it wouldnormally include indirect costs. There was general agreement withinthe Group that any duplication of costs and expenses should be prevented.

Paragraph 4 of guideline 7 reproduces the provision of article 7,paragraph 4, of the OECD Model Convention.

The Group could not reach a consensus on provisions relating tothe matters covered by article 7, paragraph 5, of the OECD Model Con-vention.5 Since no compromise could be worked out, the Group decidedto include in the guideline a note indicating that the question of whetherprofits should be attributed to a permanent establishment by reason ofthe mere purchase by that permanent establishment of goods or mer-chandise for the enterprise should be settled in bilateral negotiations.The members from developing countries considered that that paragraphshould not be reproduced in the guideline or, if it was included, shouldbe amended to include a statement to the effect that in the case of a per-manent establishment engaged in purchasing and other activities, profitsderived from purchasing activities should be attributed to the permanentestablishment.6 Furthermore, some members from developing countriesfelt that where purchasing constituted the sole activity of an enterprisein the source country, a permanent establishment would exist in thatcountry and that since the purchasing activity contributed to the gen-eration of the over-all profit of the enterprise, there should be an alloca-tion of the portion of the over-all profit attributable to the permanentestablishment. The members from developed countries believed that itwould be desirable to incorporate the provisions of article 7, paragraph5, in the text of guideline 7.

Paragraph 5 of guideline 7 reproduces article 7, paragraph 6, ofthe OECD Model Convention.

Paragraph 6 of guideline 7 reproduces article 7, paragraph 7, ofthe OECD Model Convention.

C. Shipping, inland waterways transport and air transportGuideline 8A

1. Profits from the operation of ships or aircraft in international5 Article 7, paragraph 5, of the OECD Model Convention reads as follows:

"No profits shall be attributed to a permanent establishment by reason ofthe mere purchase by that permanent establishment of goods or merchandisefor the enterprise."6The amended OECD article 7, paragraph 5, would read as follows:

"In the case of a permanent establishment engaged in purchasing andother activities, profits derived from purchase activities shall be attributed tothe permanent establishment."

58

traffic shall be taxable only in the Contracting State in which the placeof effective management of the enterprise is situated.

2. Profits from the operation of boats engaged in inland waterwaystransport shall be taxable only in the Contracting State in which the placeof effective management of the enterprise is situated.

3. If the place of effective management of a shipping enterpriseor of an inland waterways transport enterprise is aboard a ship or a boat,then it shall be deemed to be situated in the Contracting State in whichthe home harbour of the ship or boat is situated, or, if there is no suchhome harbour, in the Contracting State of which the operator of the shipor boat is a resident.

4. The provisions of paragraph I shall also apply to profits fromthe participation in a pool, a joint business or an international operatingagency.

Guideline 8B1. Profits from the operation of aircraft in international traffic

shall be taxable only in the Contracting State in which the place of effec-tive management of the enterprise is situated.

2. Profits from the operation of ships in international traffic shallbe taxable only in the Contracting State in which the place of effectivemanagement of the enterprise is situated unless the shipping activitiesarising from such operation in the other Contracting State are more thancasual. If such activities are more than casual, such profits may be taxedin that other State. The profits to be taxed in that other State shall bedetermined on the basis of an appropriate allocation of the over-all netprofits derived by the enterprise from its shipping operations. The taxcomputed in accordance with such allocation shall then be reduced byan appropriate percentage.

3. Profits from the operation of boats engaged in inland waterwaystransport shall be taxable only in the Contracting State in which the placeof effective management of the enterprise is situated.

4. If the place of effective management of a shipping enterpriseor of an inland waterways transport enterprise is aboard a ship or boat,then it shall be deemed to be situated in the Contracting State in whichthe home harbour of the ship or boat is situated, or if there is no suchhome harbour, in the Contracting State of which the operator of the shipor boat is a resident.

5. The provisions of paragraph 1 and 2 shall also apply to profitsfrom the participation in a pool, a joint business or an internationaloperating agency.

ObservationsThe OECD Model Convention contains a major exception to the

taxation of business profits on the basis of the principle of permanentestablishment, namely, the case of profits from international sea and airtransport. The latter profits are wholly exempt from tax at source andare taxed exclusively in the State in which the place of effective manage-ment of the enterprise engaged in international traffic is situated.

The exemption from tax in the source country of foreign enterprises

59

engaged in international shipping traffic is predicated largely on the prem-ise that the income of these enterprises is earned on the high seas, thatexposure to the tax laws of numerous countries is likely to result in doubletaxation or at best in difficult allocation problems, and that exemptionin places other than the home country ensures that the enterprises willnot be taxed in foreign countries if their over-all operations turn out to beunprofitable. Considerations relating to international air traffic are similar.Since many developing countries with water boundaries do not have res-ident shipping companies but do have ports used to a significant extentby ships from other countries, they have traditionally disagreed with theprinciple of such an exemption of shipping profits.

The Group agreed to recommend two alternative texts for an articlein a bilateral tax treaty relating to the taxation of profits from shipping,inland waterways transport and air transport. Alternative A (guideline8A) advocated principally by some of the developed country members ofthe Group, adopts the text of article 8 of the OECD Model Convention.Alternative B (guideline 8B) in addition to permitting tax in the countryof effective management or residence of an air transport or shipping en-terprise, provides that the other country, where the shipping activities ofan enterprise are more than casual, may also tax such profits.

The commentary on all of the paragraphs of article 8 of the OECDModel Convention is, therefore, relevant to guideline 8A. With respectto guideline 8B, the commentaries on paragraphs 2, 3 and 4 of the OECDModel Convention are relevant.

With regard to the taxation of profits from the operation of shipsin international traffic, several members from developed countries sup-ported the position taken in article 8 of the OECD Model Convention.In their view, shipping enterprises should not be exposed to the tax lawsof the numerous countries to which their operations extended; taxationat the place of effective management was also preferable from the view-point of the various tax administrations. They argued that if every coun-try taxed a portion of the profits of a shipping line, computed accordingto its own rules, the sum of those portions might well exceed the totalincome of the enterprise. According to them, that would constitute aserious problem, especially because taxes in the developing countrieswere often excessively high, and the total profits of shipping enterpriseswere frequently quite modest. However, certain members from developedcountries said they found taxation of shipping profits at the sourceacceptable.

Members from developing countries asserted that those countrieswere not in a position to forgo evea the limited revenue to be derivedfrom taxing foreign shipping enterprises as long as their own shippingindustries were not more fully developed. They recognized, however,that considerable difficulties were involved in determining a taxable profitin such a situation and allocating the profit to the various countries con-cerned. Various methods for the determination and allocation of shippingprofits were discussed.7

7 For further details, see Tax Treaties between Developed and DevelopingCountries (United Nations publication, Sales No. E.69.XVI.2), part one, paras.67-68 and ibid., Third Report (United Nations publication, Sales No. E.72.XVI.4),part one, paras. 18-3 1.

60

While certain members from developed countries expressed noserious objection to that proposal, a large number of members from de-veloped countries said they still preferred the principle of exclusivetaxation by the State in which the place of effective management of theenterprise is situated. Since no consensus could be reached on a provisionconcerning the taxation of shipping profits that could be included in theguideline, the Group agreed that the question of such taxation should beleft to bilateral negotiations.

The Group observed that countries wishing to adopt the approachembodied in the aforementioned alternative proposal might note thatthe taxation of shipping profits in the country in which those profits orig-inated (source country) was based on an operative rule for the shippingbusiness and was not qualified by the provisions of guidelines 5 and 7relating to business profits governed by the permanent establishment rule.Such taxation thus covered both regular or frequent shipping visits andirregular or isolated visits, provided the latter were planned and notmerely fortuitous. The phrase "more than casual" meant a scheduled orplanned visit of a ship to a particular country to pick up freight or pas-sengers. The over-all net profits should, in general, be determined by theauthorities of the country in which the place of effective managementof the enterprise is situated (country of residence). The final conditionsof the determination might be decided in bilateral negotiations. In thecourse of such negotiations, it might be specified, for example, whetherthe net profits were to be determined before the deduction of specialallowances or incentives which could not be assimilated to depreciationallowances but could be considered rather as subsidies to the enterprise.It might also be specified in the course of the bilateral negotiations thatdirect subsidies paid to the enterprise by a Government should be in-cluded in net profits. The method for the recognition of any losses incurredduring prior years, for the purpose of the determination of net profits,might also be worked out in the negotiations. In order to implement thatapproach, the country of residence would furnish a certificate indicatingthe net shipping profits of the enterprise and the amounts of any specialitems, including prior-year losses, which in accordance with the decisionsreached in the negotiations were to be included in, or excluded from,the determination of the net profits to be apportioned or otherwise spe-cially treated in that determination. The allocation of p-ofits to be taxedmight be based on some proportional factor specified in the bilateralnegotiations, preferably the factor of outgoing freight receipts (determinedon a uniform basis with or without the deduction of commissions). Thepercentage reduction in the tax computed on the basis of the allocatedprofits was intended to achieve a sharing of revenues that would reflectthe managerial and capital inputs originating in the country of residence.

With regard to the taxation of profits from the operation of aircraftin international traffic, several members from developing countries,although agreeing to the consensus, pointed out that no consideration hadbeen given to the very substantial expenditure that developing countriesincurred in the construction of airports. They considered that it wouldappear more reasonable to situate the geographical source of profits frominternational transportation at the place where passengers or freight werebooked.

61

D. Associated enterprises

Guideline 9

1. Where:(a) An enterprise of a Contracting State participates directly or

indirectly in the management, control or capital of an enterprise of theother Contracting State; or

(b) The same persons participate directly or indirectly in the man-agement, control or capital of an enterprise of a Contracting State andan enterprise of the other Contracting State,and in either case conditions are made or imposed between the two enter-prises in their commercial or financial relations which differ from thosewhich would be made between independent enterprises, then any profitswhich would, but for those conditions, have accrued to one of the enter-prises, but, by reason of those conditions, have not so accrued, may beincluded in the profits of that enterprise and taxed accordingly.

2. Where a Contracting State includes in the profits of an enter-prise of that State-and taxes accordingly-profits on which an enterpriseof the other Contracting State has been charged to tax in that other Stateand the profits so included are profits which would have accrued to theenterprise of the first-mentioned State if the conditions made betweenthe two enterprises had been those which would have been made betweenindependent enterprises, then that other State shall make an appropriateadjustment to the amount of the tax charged therein on those profits.In determining such adjustment, due regard shall be had to the other pro-visions of the treaty and the competent authorities of the ContractingStates shall, if necessary, consult each other.

ObservationsThe Group of Experts agreed to recommend as a suggested text for

an article in a bilateral tax treaty relating to the taxation of associatedenterprises the text of article 9 of the OECD Model Convention. Con-sequently the whole of the commentary on the latter article is relevant toguideline 9.

It was noted that guideline 9 should be considered in conjunctionwith guideline 25 on mutual agreement and guideline 26 on exchangeof information, just as article 9 of the OECD Model Convention had tobe considered in conjunction with article 25 on mutual agreement andarticle 26 on exchange of information.

E. Dividends

Guideline 10

1. Dividends paid by a company which is a resident of a Con-tracting State to a resident of the other Contracting State may be taxedin that other State.

2. However, such dividends may also be taxed in the ContractingState of which the company paying the dividends is a resident and accord-ing to the laws of that State, but if the recipient is the beneficial ownerof the dividends the tax so charged shall not exceed.:

62

(a) A certain percentage (to be established through bilateral nego-tiations) of the gross amount of the dividends if the beneficial owner is acompany (other than a partnership) which holds directly at least 10 percent of the capital of the company paying the dividends;

(b) A certain percentage (to be established through bilateral nego-tiations) of the gross amount of the dividends in all other cases.The competent authorities of the Contracting States shall by mutual agree-ment settle the mode of application of these limitations.

This paragraph shall not affect the taxation of the company in re-spect of the profits out of which the dividends are paid.

3. The term "dividends" as used in this guideline means incomefrom shares, "jouissance" shares or "jouissance" rights, mining shares,founders' shares or other rights, not being debt-claims, participating inprofits, as well as income from other corporate rights which is subjectedto the same taxation treatment as income from shares by the laws of theState of which the company making the distribution is a resident.

4. The provisions of paragraphs 1 and 2 shall not apply if thebeneficial owner of the dividends, being a resident of a Contracting State.carries on business in the other Contracting State of which the companypaying the dividends is a resident, through a permanent establishmentsituated therein, or performs in that other State independent personalservices from a fixed base situated therein, and the holding in respect ofwhich the dividends are paid is effectively connected with such permanentestablishment or fixed base. In such case the provisions of guideline 7 orguideline 14, as the case may be, shall apply.

5. Where a company which is a resident of a Contracting Statederives profits or income from the other Contracting State, that otherState may not impose any tax on the dividends paid by the company,except in so far as such dividends are paid to a resident of that otherState or in so far as the holding in respect of which the dividends are paidis effectively connected with a permanent establishment or a fixed basesituated in that other State, nor subject the company's undistributed prof-its to a tax on the company's undistributed profits, even if the dividendspaid or the undistributed profits consist wholly or partly of profits or in-come arising in such other State.

ObservationsThe 1965 report of the OECD Fiscal Committee mentioned in the

observations on guideline 5 contains the following considerations con-cerning dividends:

"The generally one-way flow of investment income from de-veloping to industrialized countries raises the question whether theOECD draft convention, which limits the withholding tax at sourceon such income, is appropriate in conventions with developing coun-tries. In considering this question, a distinction should be drawnbetween dividend income and interest income.

"Profits realized by an investor in a developing country througha subsidiary are normally taxed as business profits in that country.It is also common for a developing country to impose an additionaltax (usually by withholding at the source) on the dividends paid outof those profits. If the investor is in a country that uses the exemp-

63

tion method in dealing with foreign income, then any tax imposedby the developing country on the dividends is a burden on the in-vestor and reduces his yield. If the investor is from a country thatuses the credit approach, the withholding tax may or may not be anet additional burden on the investor, depending on the level oftax rates in the two countries and the method used in computingthe credit for foreign taxes. Thus, in a treaty between a developingcountry and a capital exporting country (using the exemption orcredit approach) it would be appropriate for limitations to be im-posed on withholding taxes on dividends. The limit might be lower,possibly, in a treaty with a country using the exemption methodthan with one using the credit method, but one cannot be categorical.It would have to depend on the facts in each case, on the level ofrates in the developing and capital exporting country, as well as onother factors.

"With respect to dividends received from portfolio investmentin a developing country, a different treaty provision may be appro-priate. Such dividends do not receive the same tax treatment either inexemption or credit countries which dividends from direct invest-ment receive. Exemption countries normally do not exempt suchdividends from tax, and the credit countries, with the notable excep-tion of the United Kingdom and Ireland in certain cases, ordinarilydo not grant a credit for the underlying corporate tax imposed bythe foreign country. Under these circumstances a treaty reduction onthe amount of withholding tax which a developing country imposesmay not contribute much towards improving capital flows to it. Whatmight be appropriate is the adoption of a credit mechanism by coun-tries that use the exemption method for direct investment and liberal-ization of the credit allowed by other countries.""The OECD Committee on Fiscal Affairs (the successor to the Fiscal

Committee) considered that limits on the taxation of dividends in thesource country were necessary in order to avoid the heavy tax burdenwhich would result from the combination of the source country's dividendwithholding tax and its basic corporate tax rate applied to the profitsfrom which the dividends are paid. It was feared that the combined effec-tive tax rate levied by the source country might reach a level that signifi-cantly exceeds the effective tax rate in the beneficiary's home country.

In the light of these and other considerations, the Group of Expertsagreed to recommend as a suggested text for an article in a bilateral taxtreaty relating to the taxation of dividends the provisions of article 10 ofthe OECD Model Convention with three substantive changes, namely, thedeletion of the phrases "5 per cent" in paragraph 2, subparagraph (a),and "15 per cent" in paragraph 2, subparagraph (b), and their replacementby the phrase "a certain percentage (to be established through bilateralnegotiations)", and the replacement of the phrase "25 per cent" in thatparagraph by the phrase "10 per cent". The commentary on article 10of the OECD Model Convention is relevant mutatis mutandis to guide-line 10.

Paragraph 1 of guideline 10 reproduces the provisions of article 10,8 Organization for Economic Co-operation and Development, op. cit., paras.

176-178.

64

paragraph 1, of the OECD Model Convention. By providing simply thatdividends may be taxed in the State of the beneficiary's residence, theparagraph does not prescribe that dividends should be taxed exclusivelyin that State and leaves open the possibility of taxation by the State ofwhich the company paying the dividends is a resident, that is, the Statein which the dividends originate (source country). Although agreeing tothe consensus on paragraph 1 of guideline 10, many members from de-veloping countries felt that as a matter of principle dividends should betaxed only by the source country. According to them, if both the countryof residence and the source country were given the right to tax, the coun-try of residence should grant a full tax credit regardless of the amount offoreign tax to be absorbed and, in appropriate cases a tax-sparing credit.One of those members emphasized that there was no necessity for a de-veloping country to waive or reduce its withholding tax on dividends,especially if it offered tax incentives and other concessions.

Paragraph 2 reproduces the provisions of article 10, paragraph 2,of the OECD Model Convention with three substantive changes men-tioned above. In subparagraphs (a) and (b) the phrase "a certain percent-age (to be established through bilateral negotiations)" was used becausethe Group was unable to reach a consensus on the percentages of thegross amount of the dividends. The members from developing countries,who basically preferred the principle of the taxation of dividends exclu-sively in the source country, considered that the adoption of the percent-ages (the gross amount of the dividends) used in article 10, paragraph 2,of the OECD Model Convention would entail too large a loss of revenuefor the source country. Nevertheless they were not opposed to taxationin the beneficiary's country of residence provided that any reduction inwithholding taxes in the source country benefited the foreign investorrather than the treasury of the Government of the beneficiary's countryof residence, as was the case under the traditional tax-credit methodwhenever the reduction lowered the cumulative tax rate of the sourcecountry below the rate of the beneficiary's country of residence.

The OECD Model Convention, while recognizing source jurisdic-tion based on payment alone, greatly restricts the amount of withholdingtax to be applied by the source jurisdiction, givesno attention to a deter-mination of what expenses in the residence country are attributable tothe dividends.9 This is presumably because traditionally the expenses ofa shareholder in the residence country allocable to the receipt of a divi-dend are not regarded as deductible in the source country, unlike expensesallocable to interest or royalties. Hence the level of source country with-holding taxes on dividends has not been fixed in treaties with regard toshareholders' expenses.

Concerning the substantive change in paragraph 2 of guideline 10,namely, the replacement of the phrase "25 per cent" by the phrase "10per cent", there was general agreement in the Group regarding the figureof 10 per cent. In setting that figure, the Group took account of the factthat in some developing countries non-residents were limited to 50 percent share ownership, so that 10 per cent represented a significant portionof such permitted ownership.

9 This matter was not considered by the Group of Experts.

65

The Group of Experts felt that in the bilateral negotiations relatingto the percentage of gross amount of the dividends if the beneficial ownerholds directly at least 10 per cent of the capital of the company payingthe dividends, the negotiating countries might be guided by the followingconsiderations:

First, if the developed (residence) country uses a credit system, thenegotiations could appropriately seek a limitation on withholding taxrates at source that would, in combination with the basic corporate taxrate of the source country, produce a combined effective rate that doesnot exceed the tax in the residence country. In ascertaining the effectiverate that exists in the absence of limitation, consideration might be givento the effect of tax incentives and other provisions in the source countryaffecting the rates of tax. Hence, a treaty could provide for different with-holding rates at different stages of activity of an enterprise as incentivemeasures ceased to be operative. Distinctions might be drawn in the ne-gotiations, if appropriate and feasible, between old and new investments.This over-all approach could result in varying reductions in the withhold-ing rates of the same source country in various treaties, depending uponthe relationship between the combined effective rate of the source countryand the rates of the different residence countries. In other words, thetreaties of a residence country may contain varying reductions in with-holding rates among the developing countries with which it has treaties.Any limitation in withholding rates so negotiated would of necessity bea benefit to the investor, since it would be the purpose of the limitationto reduce the effective rate of the source country to the credit level of theresidence country.

Secondly, if the developed country uses an exemption system fordouble-taxation relief, it may, in bilateral negotiations, seek a limitationon withholding rates on several grounds: (a) that the exemption itselfstresses the concept of not taxing intercorporate dividends, and a limita-tion of the withholding rate at source would be in keeping with that con-cept; (b) that the exemption and resulting departure from tax neutralitywith domestic investment are of benefit to the international investor, andhence a limitation of the withholding rate at source would be in keepingwith this step, since that limitation would also benefit the investor.

Thirdly, with respect to portfolio investment, both the source coun-try and the residence country should be in a position to tax dividendspaid on the shares involved, although the relatively small amount ofportfolio investment and its distinctly lesser importance compared withdirect investment might make the issues concerning its tax treatment lessintense.

Paragraphs 3, 4 and 5 of guideline 10 reproduce the provisions ofarticle 10, paragraphs 3, 4 and 5 of the OECD Model Convention.

F. Interest

Guideline 11

1. Interest arising in a Contracting State and paid to a residentof the other Contracting State may be taxed in that other State.

2. However, such interest may also be taxed in the Contracting

66

State in which it arises and according to the laws of that State, but if therecipient is the beneficial owner of the interest the tax so charged shallnot exceed a certain percentage of the gross amount of the interest (tobe established through bilateral negotiations). The competent authoritiesof the Contracting States shall by mutual agreement settle the mode ofapplication of this limitation.

3. The term "interest" as used in this guideline means income fromdebt-claims of every kind, whether or not secured by mortgage andwhether or not carrying a right to participate in the debtor's profits and,in particular, income from government securities and income from bondsor debentures, including premiums and prizes attaching to such securities,bonds or debentures. Penalty charges for late payment shall not be re-garded as interest for the purpose of this guideline.

4. The provisions of paragraphs 1 and 2 shall not apply if thebeneficial owner of the interest, being a resident of a Contracting State,carries on business in the other Contracting State in which the interestarises, through a permanent establishment situated therein, or performsin that other State independent personal services from a fixed base situ-ated therein, and the debt-claim in respect of which the interest is paidis effectively connected with such permanent establishment or fixed base.In such case the provisions of guideline 7 or guideline 14, as the case maybe, shall apply.

5. Interest shall be deemed to arise in a Contracting State whenthe payer is that State itself, a political subdivision, a local authority or aresident of that State. Where, however, the person paying the interest,whether he is a resident of a Contracting State or not, has in a Contract-ing State a permanent establishment or a fixed base in connexion withwhich the indebtedness on which the interest is paid was incurred, andsuch interest is borne by such permanent establishment or fixed base, thensuch interest shall be deemed to arise in the State in which the permanentestablishment or fixed base is situated.

6. Where, by reason of a special relationship between the payerand the beneficial owner or between both of them and some other person,the amount of the interest, having regard to the debt-claim for which it ispaid, exceeds the amount which would have been agreed upon by thepayer and the beneficial owner in the absence of such relationship, theprovisions of this guideline shall apply only to the last-mentioned amount.In such case, the excess part of the payments shall remain taxable accord-ing to the laws of each Contracting State, due regard being had to theother provisions of the treaty.

Observations

Interest, which, like dividends, constitutes income from movablecapital, may be paid to individual savers who have deposits with banksor hold savings certificates, to individual investors who have purchasedbonds, to individual suppliers or trading companies selling on a deferredpayment basis, to financial institutions which have granted loans or toinstitutional investors which hold bonds or debentures. Interest may alsobe paid on loans between associated enterprises.

At the national level, interest is usually deductible from the figures

67

used for calculating profits. In this context, any tax on interest is paid bythe beneficiary unless a special contract provides that it should be paidby the payer of the interest. Contrary to what occurs in the case of divi-dends, it is not liable to double taxation, that is, taxation in the handsof both the beneficiary and the payer. If the latter is obliged to withholda certain portion of the interest as a tax, the interest thus withheld repre-sents an advance on the amount of tax to which the beneficiary will beliable on his aggregate income or profits at the end of the fiscal year. Atthat time, the beneficiary can deduct the amount withheld by the payerfrom the amount of tax due from him and obtain reimbursement of anysum by which the amount withheld exceeds the amount of the tax that isfinally payable. This mechanism prevents the beneficiary from beingtaxed twice on the same interest.

At the international level another set of circumstances usually pre-vails. When the beneficiary of the interest is a resident of one countryand the payer of the interest is a resident of another, the same interestis subject to taxation in both countries. This double taxation may con-siderably reduce the net amount of interest received by the beneficiaryor, if the payer has agreed to bear the cost of the tax deductible at thesource, will increase the financial burden on the payer.

The OECD Model Convention sets a maximum of 10 per cent forthe tax withheld at source instead of leaving that maximum to be deter-mined by mutual agreement between the Contracting States. It provides,however, for taxation at source when the person paying the interest hasin a Contracting State a permanent establishment or fixed base in con-nexion with which the indebtedness on which the interest is paid wasincurred.

The 1965 report of the OECD Fiscal Committee mentioned earliercontains the following considerations concerning the tax treatment ofinterest:

"The tax status of interest in the industrialized country is sub-stantially the same as that of dividends from portfolio investment.Consequently, the same general conclusions might be drawn, namely,that a limitation of withholding taxes on interest or the exemptionof interest, which is common in treaties between capital exportingcountries, also is not justified. However, there are additional con-siderations involved. Withholding is often on a gross basis and doesnot take into account the costs incurred by a lender. A limitationon the withholding rate compensates for the fact that it is on a grossbasis. Moreover, banks and other institutions which make loans todeveloping countries often insist that the interest called for in theloan instrument shall be free of any taxes imposed in the countryof the borrower. If the interest is subject to tax then the borrowermust assume the burden involved. There may be various factorsresponsible for such provision in a loan contract. It may simply bea convenient device for increasing the rate of interest that wouldotherwise be obtainable although in general one might expect lendersto charge whatever the traffic will bear. In addition, such a clauseoffers assurance to the lender that there will be no diminution in theyield from the loan as a result of changes in the tax policy of the

68

developing country. The exemption provision in the contract mayalso help to widen the market for the loan instrument if the lendershould later wish to sell it. Thus, exemption of interest in a taxtreaty may have the effect of reducing the cost of borrowed capital.But it should also be noted that a treaty provision which providestax exemption for interest and not for dividends may create ad-ministrative difficulties for developing countries. Investors will tendto make more loan than equity capital available to their controlledenterprises and administrators will have to determine when there isan excess of indebtedness. In view of these factors it seems clearthat there can be no hard and fast rule with respect to the tax treat-ment to be accorded interest in conventions between developingand industrialized countries."10

Within the Group of Experts, there was strong feeling on the partof members from developing countries that those countries should havethe exclusive, or at least the primary, right to tax interest. According tothat view, it was incumbent on the developed countries to prevent doubletaxation of that income through exemption, credit or other relief mea-sures. These members reasoned that interest should be taxed where it wasearned, that is, where the capital was put to use. The taxing of interestwould also have a significant effect on the economies of developing coun-tries because, apart from its contribution to revenues, it would reduce theoutflow of foreign exchange. Some members from developed countriesfelt that the home country of the investor should have the exclusive rightto tax interest, since, in their view that would promote the mobility ofcapital and give the right to tax to the country which was best equippedto consider the characteristics of the taxpayer. Other members fromdeveloped countries felt that the developed countries should have theprimary right to tax interest and that the country in which the investmentwas made should make the necessary accommodations to ensure that itstax would be fully offset against the tax of the investor's home country,thus providing tax neutrality as between domestic and foreign invest-ment. They also pointed out that an exemption of foreign interest fromthe tax of the investor's home country might not be in the best interestsof the developing countries because it could induce investors to placetheir capital in the developing country with the lowest tax rate. Membersfrom developing countries contested that view and stated that tax rateswere only one of the factors involved in investments. Members fromdeveloped countries also drew attention to the fact that under currentconditions, the greater part of international loan capital was providedby banks, pension funds and other large financial institutions, and thatimposition of high withholding taxes on such loans would either makethe investment unattractive to institutional lenders, which in any casepreferred loans to domestic borrowers, or increase the cost of the loanto the borrower.

During the discussions, it was stressed that in order to take accountof the fact that, in the international field, interest mainly relates to pay-ments to financial institutions and that the gross figure does not neces-sarily correspond to net income, in certain developing countries, interest

10 Organization for Economic Co-operation and Development, op. cit., para.179.

69

payable to non-residents is taxed on a net basis if the lender is engagedin business in the country; otherwise it is taxed on a gross basis. Membersfrom those countries generally were of the opinion that interest should betaxed on a gross basis, both for administrative convenience and for sub-stantive reasons. They generally agreed that withholding taxes on interestincome should be set at a rate corresponding to the usual corporate taxrate on net income. They conceded that the tax on interest could behigher than that on business income under that method. In that respect,one member from a developing country stressed the importance of taxingon a gross basis as a matter of practical administration, though recog-nizing that the actual rate on gross interest used should, to the extentfeasible, take account of the fact that expenses were involved in theearning of the interest.

As a compromise the Group of Experts agreed to recommend as asuggested text for an article in a bilateral tax treaty relating to the taxa-tion of interest the text of article 11 of the 1977 OECD Model Conven-tion with one substantive change, namely, the deletion of the phrase"shall not exceed 10 per cent of the gross amount of the interest" fromthe first sentence of paragraph 2 and its replacement by the phrase "shallnot exceed a certain percentage of the gross amount of the interest (to beestablished through bilateral negotiations)". The commentary on article11 is therefore relevant mutatis mutandis to guideline 11.

Paragraph 1 of guideline 11 reproduces the provisions of article 11,paragraph 1, of the OECD Model Convention.

Paragraph 2 reproduces the provisions of article 11, paragraph 2, ofthe OECD Model Convention with the substantive change mentionedabove. The members from developing countries agreed to the solutionof taxation by both the country of residence and the source countryembodied in article 11, paragraphs 1 and 2, of the OECD Model Con-vention but found the ceiling of 10 per cent of the gross amount of theinterest mentioned in paragraph 2 thereof unacceptable. It may be notedin that connexion that within OECD the 10 per cent ceiling has beenconsidered "a reasonable maximum" in the light of the fact that thesource country was already entitled to tax profits on income produced inits territory by investments financed out of funds borrowed abroad.Since the Group was unable to reach a consensus on an alternative higherceiling the matter was left to bilateral negotiations.

Within the framework of the Group's compromise solution, a veryrelevant question is that of the expenses involved in the earning of theinterest. Clearly, the gross interest on such loans is far higher than thenet profit, since banks incur large expenses in attracting the funds con-stituting the loans. While the Group recognized the importance of ex-penses, it considered that no precise ratio of expenses to gross interestcould be provided. The target as far as expenses were concerned was therate of withholding tax on gross interest that would approximate the taxproceeds resulting from the application of the regular domestic businesstax of the source country to the net income component of the interest,that is, gross interest less expenses applicable to that gross interest. Awithholding rate so determined would indirectly take account of theexpense component of the interbst.

70

A precise level of withholding tax for a source country should takeinto account a number of factors including the following: the fact that thecapital originated in the residence country; the possibility that a highsource rate might cause lenders to pass the cost of the tax on tothe borrowers, which would mean that the source country would increaseits revenue at the expense of its own residents rather than the foreignlenders; the possibility that a tax rate higher than the foreign tax creditlimit in the residence country might deter investment; the fact that alowering of the withholding rate has revenue and foreign exchange con-sequences for the source country and the fact -that interest flows mainlyin one direction, namely, from developing to developed countries.

In that connexion, it may be of interest to note that the withholdingrates imposed on interest in developing countries seem to be somewhatlower than those imposed on dividends. Some developing countries im-pose no tax. A 15 per cent rate is fairly common; there are also instancesof 10 and 20 per cent rates, but very few countries impose rates between30 and 40 per cent.

Paragraphs 3, 4, 5 and 6 of guideline 11 reproduce the provisionsof article 11, paragraphs 3, 4, 5 and 6, of the OECD Model Convention.

In connexion with the guideline on interest, the Group discussed thequestion of what considerations would be involved if two countries whichhad generally agreed on a treatment of interest entailing a withholdingrate on gross interest subsequently desired specifically to consider intereston deferred-payment sales. It was recalled that side by side with conven-tional transactions for the sale of raw materials or goods on short-termcredit, sales of heavy capital goods and large-scale public works gave riseto credits which had steadily increased in size and duration, from anaverage of from three to five years in the 1950s to more than 20 years incertain cases. It was suggested that the character of interest should berecognized not only where interest was specified in the contract, buteven where the instalment payments made no distinction between the partof the payment corresponding to the purchase price and the part repre-senting financial charges. In the latter case, it might be somewhat difficultto determine what part represented interest, although it was possible toisolate the interest component by comparing the total sum to be paid bythe purchaser with the cash value of the article purchased.

It was indicated that if a country wished to tax interest on creditsales, the aim should be to tax only net interest, i.e., the amount of theprofit which could be made on the interest paid. However, sales credits,and in particular long-term credits, were generally granted, not by thesuppliers themselves out of their own funds, but by banks or other finan-cial institutions, which, in turn, had to obtain their resources on the moneymarket at borrower's interest. As their profit was far smaller than thegross interest received, the amount of tax payable in the lender's countrymight be less than the amount of tax levied in the debtor's country on thegross amount of interest paid. The procedure for granting credit and theconditions on which it was granted varied according to whether short-term or long-term credit was involved. Short-term credits correspondedto commercial transactions; hence, the accompanying interest was im-mediately passed on. Long-term credits corresponded to investmentswhich should be profitable enough to be repaid in instalments over a

71

period. In the latter case, interest must be paid out of earnings at thesame time as instalments of credit were repaid out of capital. Conse-quently, any excessive fiscal burden on such interest must be passed onto the book value of the capital goods purchased on credit, with the re-sult that the fiscal charge levied on the interest might, in the last analysis,diminish the amount of tax payable on the profits made by the user of thecapital goods.

It was observed that long-term credits, which, in reality, weregranted only in international transactions, called for special guaranteesowing to the difficulty of long-term political, economic and monetaryforecasting. Moreover, the Governments of the majority of developedcountries, in order to ensure full employment in their capital goods in-dustries or public works enterprises, had adopted various measures whichadded up to privileged treatment for long-term credits in the form ofcredit insurance or interest-rate reductions by government agencies. Suchadvantages might be granted in the form of direct loans by such agenciestied to loans from private banks (the Export-Import Bank in the UnitedStates of America was an example) or by private banks which enjoyedcreditfacilities or interest terms more favourable than those obtainableon the money market.

It was also observed that competition among industrialists in thedeveloped countries had the effect of increasing the volume of creditgranted by those countries to developing countries and of giving them thebenefit of below-normal interest rates. Such advantages could not, as arule, be granted without the co-operation of the public authorities in thedeveloped countries, which in turn would find it difficult to agree to suchsacrifices if the corresponding advantages were to be cancelled out orreduced by taxation in the debtor's country which was considered exces-sive. Under tax treaties, countries normally agreed not to tax interestpaid on loans granted by a Government or by an agency of the Govern-ment. The issue was thus raised whether that attitude should equally applyin favour of interest on long-term loans made by private banks wheresuch loans were guaranteed or refinanced by a Government or by anagency of the Government.

It was further observed that over and above the purely fiscal aspectsof the treatment of interest, there were economic considerations; forexample, taking into account the real rate of interest, there was the pos-sibility, in a market characterized by a steadily growing demand for cap-ital, of passing on to the borrower any burden imposed on interest.

In the light of the foregoing, it was suggested that when two countriesnegotiating a tax treaty took up the question of interest on deferred pay-ment sales, the country of the seller might draw attention to a numberof factors that would in its view justify different treatment for such inter-est. Thus it could ask whether the negotiating parties really wanted tobecome involved in such questions, which might be difficult to solve asseparating discount and short-term credit sales from long-term sales; ordetermining- the implied interest rate when no explicit rate was stated(and then, perhaps, using for the sake of consistency only the basic salesprice for custom valuation purposes) or considering whether distinctionsshould be drawn in tax treaties between export credit granted directly orby a government agency and credit granted by commercial institutions

72

which were, in turn, assisted or backed by governmental bodies. More-over, related economic issues might have to be faced if that interest wereto be taxed, such as, perhaps, the seller's effort to shift the burden of thetax to the buyer in view of the amounts involved and the effect that the in-trusion of a tax could have on the terms of the basic transaction and theextension of credit itself. The factors involved might in the actual pro-cess of negotiation cause some countries to decide not to pursue thetaxation of such interest even though, otherwise, interest payments weretaxed. However, such factors might not appear sufficiently persuasive tosome negotiators. In the latter case, the consideration could still arisewhether the margin of actual net profit on the extension of such creditwas less than the profit margins the negotiators had had in mind whenthey had set the general withholding rate on interest. Moreover, in someexport credit situations, whatever the margin of profit that arose, thatmargin might be earned not by the seller, but by the financial institutionwith which the seller had refinanced the transaction so that the sellermight have problems in absorbing a tax at source. Those factors mightpersuade some negotiators to decide against taxing such interest or atleast to provide a more favourable rate than for interest in general; othernegotiators might be less influenced by those factors.

The Group therefore concluded that, while interest on deferred-payment or credit sales should be considered in the context of the treatyarticle on interest, the nature of that consideration and the final resolutionshould be settled through negotiations between the parties.

G. Royalties

Guideline 12

1. Royalties arising in a Contracting State and paid to a residentof the other Contracting State may be taxed in that other State.

2. However, such royalties may also be taxed in the ContractingState in which they arise and according to the laws of that State, but ifthe recipient is the beneficial owner of the royalties, the tax so chargedshall not exceed a certain percentage of the gross amount of the royalties(to be established through bilateral negotiations). The competent author-ities of the Contracting States shall by mutual agreement settle the modeof application of this limitation.

3. The term "royalties" as used in this guideline means paymentsof any kind received as a consideration for the use of, or the right to use,any copyright of literary, artistic or scientific work including cinemato-graph films, any patent, trade mark, design or model, plan, secret formulaor process, or for the use of, or the right to use, industrial, commercial,or scientific equipment, or for information concerning industrial, com-mercial or scientific experience.

4. The provisions of paragraphs 1 and 2 shall not apply if thebeneficial owner of the royalties, being a resident of a Contracting State,carries on business in the other Contracting State in which the royaltiesarise, through a permanent establishment situated therein, or performsin that other State independent personal services from a fixed base sit-uated therein, and the right or property in respect of which the royalties

73

are paid is effectively connected with such permanent establishment orfixed base. In such case the provisions of guideline 7 or guideline 14, asthe case may be, shall apply.

5. [This paragraph is to relate to the definition of the source ofroyalties. Since the Group has not yet dealt with the question of suchdefinition, it was agreed that in the meantime it should be arrived at inbilateral negotiations.]

6. Where, by reason of a special relationship between the payerand the beneficial owner or between both of them and some other person,the amount of the royalties, having regard to the use, right or informationfor which they are paid, exceeds the amount which would have beenagreed upon by the payer and the beneficial owner in the absence of suchrelationship, the provisions of this guideline shall apply only to the last-mentioned amount. In such case, the excess part of the payments shallremain taxable according to the laws of each Contracting State, dueregard being had to the other provisions of the treaty.

Observations

When the user of a patent or similar property is resident in onecountry and pays royalties to the owner thereof who is resident in an-other country, the amount paid by the user is generally subject to with-holding tax in his country, that is, the source country. The latter countrydoes not inquire into the nature of the payments made to the owner andimposes a tax on the gross payments. It thus does not take into accountany related expenses that may have been incurred by the owner. Withoutsuch recognition of expenses, the after-tax profit which the owner receivesmay in some cases be only a small percentage of gross royalties. Con-sequently, in practice, the owner may have to take the withholding taxin the source country into account in fixing the amount of the royalty, sothat the user and the source country will pay more for the use of thepatent or similar property than they would if the withholding tax leviedby the source country were lower and took into account the expensesincurred by the owner. A manufacturing enterprise or an inventor mayhave spent substantial sums on the development of the property generat-ing the royalties, because the work of research and testing involves con-siderable capital outlays and does not always yield successful results. Theproblem of determining the appropriate tax rate to be applied by thesource country to gross royalty payments is therefore complex, especiallysince the user may make a lump sum payment for the use of the patentor similar property, in addition to regular royalty payments.

The OECD Model Convention lays down the principle of exclusivetaxation of royalties in the State of the beneficial owner's residence andtherefore exempts them from taxation at the source, except where theright or property in respect of which the royalties are paid is "effectivelyconnected" with a permanent establishment or fixed base of the recipientsituated in the source country.

The 1965 report of the OECD Fiscal Committee mentioned abovecontains the following considerations relating to the tax treatment ofroyalties:

"The tax treatment of royalties involves some of the same issuesas interest. Developing countries, however, view the tax treatment of

74

royalties from a somewhat different perspective; they tend to regardincome from the licensing of patents and know-how as a superfluity towhich the owner of the rights that are licensed has relatively littleclaim. The license may be valuable, but it is not considered tojustify any special tax consideration by a developing country. Thisattitude fails to take into account, however, that licensors are com-monly engaged in a continuous process of developing patents andtechnical know-how with an eye for potential markets in much thesame way as producers of tangible products. The costs of develop-ment must be borne from the yield from all licensees. Moreover,licensing entails direct costs. The licensor must assure himself ofthe quality of the product produced by the licensee. He must policethe license against infringement. He must supply technical assistanceand information on improvements in the field covered by the patent.Since the license may be issued to one of a number of alternativeapplicants, the licensor is apt to make selections from among them.Such a choice will be made on the basis of a variety of factors, in-cluding the taxes imposed on the royalties by the country in whichthe licensee is situated, and the opportunity for "grossing-up" theroyalty to include those taxes. One possible solution to this problemwould be a treaty provision under which a developing country wouldtax royalties on a net basis at a moderate rate or, if on a gross basis,at a rate that would be more or less equivalent to the tax that wouldapply if a net basis were used.""The Group agreed to recommend as a suggested text for an article

in a bilateral tax treaty relating to the taxation of royalties the text ofarticle 12 of the OECD Model Convention with a number of substantivechanges in paragraphs 1 and 4, and the insertion of a new paragraph 2and a new paragraph 5, the remaining paragraphs being renumbered ac-cordingly. The commentary on article 12 of the OECD Model Conventionis therefore relevant mutatis mutandis to guideline 12.

During the discussion in the Group of Experts, the members fromdeveloping countries expressed the view that in order to facilitate theconclusion of tax treaties between those countries and developed coun-tries, the primary right to tax royalties should be given to the countrywhere that income arose, that is, the source country. Those members ob-served that patents and processes were usually licensed to developingcountries after they had been fully exploited elsewhere. According tothem, although it would be going too far to assert that such propertieswere made available to developing countries only when they had becomeobsolete, it would be no overstatement to say that they arrived at a latestage, when the expenses incurred in connexion with their developmenthad already been largely recouped.

Members from developed countries considered that it would be un-realistic to assume that enterprises selected the oldest patents for licensingto developing countries. Normally, an enterprise would license its patentsto foreign subsidiaries and therefore select the most up-to-date inventions,in the hope of expanding existing markets or opening new ones. A mem-ber from a developed country emphasized that it should be borne in mind

11 Organization for Economic Co-operation and Development, op. cit., para.180.

75

that patents were not merchandise, but instruments for promoting indus-trial production. Several members from developed countries held as amatter of principle that the country of residence of the owner of a patentor similar property should have the exclusive or primary right to taxroyalties paid thereon.

Since no consensus emerged concerning a specific rate for the with-holding tax to be charged on royalties on a gross basis, it was decidedthat the rate should be established through bilateral negotiations. Thatdecision is reflected in paragraph 2 of guideline 12. The Group agreedthat the following considerations might be taken into account in suchnegotiations:

First, the country of source, in establishing a withholding tax onthe gross royalty in a tax treaty, would, from the standpoint of the effectof expenses allocable to the royalty payments, recognize that both currentexpenses allocable to the royalty and expenditures incurred in the devel-opment of the property whose use gave rise to the royalty were to beconsidered, bearing in mind that the latter expenditures were also allo-cable to profits derived from other royalties jor activities, past or future,associated with those expenditures, and also that other expenditures notdirectly incurred in the development of that property might, nevertheless,have contributed significantly to that development;

Secondly, as a technical matter, if an expense ratio were agreed uponin fixing a gross rate in the source country, it would appear as a conse-quence that the country of the recipient, if following a credit method,would apply that expense ratio as the basis for determining the applica-tion of its credit, whenever feasible. Therefore, that matter should beconsidered under guideline 23A or 23B.

In addition various members of the Group mentioned factors whichin their view might influence the determination of the withholding tax ongross royalties. Those factors included the following: the need for reve-nue and conservation of foreign exchange by the developing countries;the fact that royalty payments flowed almost entirely from developingcountries to developed countries; the extent of assistance that developedcountries should, for a variety of reasons, extend to developing countries,and the special importance of providing such assistance in the context ofroyalty payments; the desirability of preventing a shifting in the licencearrangement of the tax burden to the licencees; the ability that taxationat source provided to a developing country to make selective judgmentsby which, through reduced taxation or exemption, it could encouragethose licence arrangements if considered desirable for its development;the lessening of the risks of tax evasion if there was, in fact, at least taxa-tion at the source; the fact that the country of the licensor supplied thefacilities and activities necessary in the development of the patent andthus undertook the risks associated with the patent; the desirability ofobtaining and encouraging a flow of technology to developing coun-tries; the desirability of enlarging the field of activity of the licensor inthe utilization of his research; the benefits that developed countries wouldobtain from world development in general; the relative importance ofrevenue sacrifice; and the relationship of the royalty decision to otherdecisions in the negotiations.

76

The Group also considered a problem involving the broad definitionof royalties. A member from a developed country explained that in hisview the problem was that the definition made an imperfect distinctionbetween revenues that constituted royalties in the strict sense and pay-ments received for brain-work and technical services, such as surveysof any kind (engineering, geological research etc.). The member alsomentioned the problem of distinguishing between royalties akin to in-come from capital and payments received for services. Given the broaddefinition of "information concerning industrial, commercial or scientificexperience", certain countries tended to regard the provision of brain-work and technical services as the provision of "information concerningindustrial, commercial or scientific experience" and to regard paymentfor it as therefore taxable as royalties.

In order to avoid those difficulties, the member from a developedcountry proposed that the definition of royalties be restricted by exclud-ing from the definition payments received for "information concerningindustrial, commercial or scientific experience". The member also sug-gested that there be a protocol annexed to the treaty making it clear thatsuch payments should be deemed to be profits of an enterprise to whichguideline 7, dealing with business profits, would apply and that paymentsreceived for studies or surveys of a scientific or technical nature, suchas geological surveys, or for consultant or supervisory services, should bedeemed to be profits of an enterprise to which the provisions of guideline7 would apply. It was pointed out that the effect of those different pro-visions would be to ensure that the source country could not tax suchpayments unless the enterprise had a permanent establishment, as definedby the treaty, situated in that country, and that taxes should be payableonly on the net income element of such payments attributable to thatpermanent establishment.

On the other hand, a member from a developing country pointedout that the narrower definition of royalties suggested by the memberfrom a developed country would help to clarify the interpretation ofguideline 12, paragraph 2. But if the definition of royalties was left un-changed in the OECD Model Convention, he understood that brain-workand technical services would be covered by the expression "informationconcerning industrial, commercial and technical experience", and as suchwould be included in the definition of royalties.

In order to solve the problem of the definition of royalties the Groupagreed to consider income from such activities as business profits and toinclude in guideline 5, paragraph 3, a new subparagraph (b) which pro-vides that the term permanent establishment should likewise encompass"the furnishing of services, including consultancy services, by an enter-prise through employees or other personnel, where activities of that naturecontinue (for the same or a connected project) within the country for aperiod or periods aggregating more than six months within any twelve-month period".

With regard to film rentals, there was a consensus that income fromsuch rentals should not be treated as industrial and commercial profitsbut in the context of royalties. The tax would thus be levied on a grossbasis but expenses would be taken into account in fixing the withholding

77

rate. With regard to expenses, some members mentioned factors thatcould be regarded as peculiarly relevant to film rentals. Thus, it was saidthat, as a general rule, the expenses of film producers might be muchhigher and the profits lower than in the case of industrial royalties. Onthe other hand, it was pointed out that a considerable part of film ex-penses represented high salaries paid to actors and other participantswho were taxed solely by the country of residence, and not by the sourcecountry, and might therefore not justify any great reduction of the with-holding tax at source. However, it could be said that the amounts in-volved were, nevertheless, real costs for the producer and should be takeninto account, while, at the same time, all countries involved should joinin efforts to make sure that such income did not escape tax. Further,while the write-off of expenses in the country of residence did not meanthat the expenses should not be taken into account at source, at somepoint old films could present a different expense situation.

With regard to copyright royalties, some members felt that becausesuch royalties represented cultural efforts, they should be exempted fromtax by the source country. Other members, however, felt that that wasmerely a sentimental gesture, and that since tax would be levied by theresidence country, the reduction at source would not benefit the author.Other members were in favour of exempting copyright royalties at thesource, not necessarily for cultural reasons, but because the residencecountry was in a better position to evaluate the expenses and personalcircumstances of the creator of the royalties, including the period of timeover which the books or other copyrighted items had been created; a re-duction of the source-country tax could be supported in some cases bythe fact that the tax was too high to be absorbed by the tax credit of theresidence country. However, it was recognized that source countriesmight not be willing to accept that approach to the problem. Further,those contending for exemption of the royalties by the source country oncultural grounds faced certain problems. The party dealing with thesource country might be the publisher and not the author, and argumentssupporting the exemption of the author's income because of his personalsituation obviously do not apply to the publisher.

Paragraphs 3, 4 and 6 of guideline 12 reproduce the provisions ofarticle 12, paragraphs 2, 3 and 4 of the OECD Model Convention witha minor change in paragraph 4 of guideline 12, namely, the addition of"and 2" after "the provisions of paragraph 1".

As to paragraph 5, it should deal with the definition of the source ofroyalties but since the Group had not yet considered the question ofsuch definition it was agreed that in the meantime it should be arrivedat in bilateral negotiations. There was suggestion that if in such negotia-tions it was decided that the article relating to royalties should include aparagraph dealing with a definition of the source of royalties, that defi-nition should be formulated along the following lines:

"Royalties shall be deemed to arise in a Contracting State whenthe payer is that State itself, a political subdivision, a local authorityor a resident of that State. Where, however, the person paying theroyalties, whether he is a resident of a Contracting State or not, hasin a Contracting State a permanent establishment or a fixed base in

78

connexion with which the liability to pay the royalties was incurred,and such royalties are borne by such permanent establishment orfixed base, then such royalties shall be deemed to arise in the Statein which the permanent establishment or fixed base is situated."

A member from a developed country suggested that those countrieswhich wish to do so might substitute for the source rule specified in theguidelines a rule which would identify the source of a royalty as theState in which the property or right giving rise to the royalty (the patentetc.) was used. Where, in bilateral negotiations, the two parties differedon the appropriate rule, a possible solution would be a rule which, in gen-eral, would accept the place of residence of the payer as the source ofroyalty; but where the right or property for which the royalty was paidwas used in the State having a "place of use" rule, the royalty would bedeemed to arise in that State.

H. Capital gains

Guideline 13

1. Gains derived by a resident of a Contracting State from thealienation of immovable property referred to in guideline 6 and situatedin the other Contracting State may be taxed in that other State.

2. Gains from the alienation of movable property forming partof the business property of a permanent establishment which an enter-prise of a Contracting State has in the other Contracting State or ofmovable property pertaining to a fixed base available to a resident of aContracting State in the other Contracting State for the purpose of per-forming independent personal services, including such gains from thealienation of such a permanent establishment (alone or with the wholeenterprise) or of such fixed base, may be taxed in that other State.

3. Gains from the alienation of ships or aircraft operated in inter-national traffic, boats engaged in inland waterways transport or movableproperty pertaining to the operation of such ships, aircraft or boats, shallbe taxable only in the Contracting State in which the place of effectivemanagement of the enterprise is situated.

4. Gains from the alienation of shares of the capital stock of acompany the property of which consists directly or indirectly principallyof immovable property situated in a Contracting State may be taxed inthat State.

5. Gains from the alienation of shares other than those mentionedin paragraph 4 representing a substantial participation in a companywhich is a resident of a Contracting State may be taxed in that State.

6. Gains from the alienation of any property other than that re-ferred to in paragraphs 1, 2, 3, 4 and 5 shall be taxable only in the Con-tracting State of which the alienator is a resident.

ObservationsThe Group of Experts agreed to recommend as a suggested text

for an article in a bilateral tax treaty relating to the taxation of capitalgains the first three paragraphs of article 13 of the OECD Model Con-vention followed by two new paragraphs (paragraphs 4 and 5) and by the

79

text of article 13, paragraph 4, of the OECD Model Convention renum-bered as paragraph 6 and adjusted to take into account the insertion ofthe two new paragraphs. The commentary on article 13 of the OECDModel Convention is therefore relevant mutatis mutandis to guideline 13.

The Group observed that paragraph 4 was designed to preventavoidance of taxes on the gains from the sale of immovable property.Since it would often be relatively easy to avoid taxes on such gains throughincorporation of such property, it was necessary to tax the sale of sharesin such a company. That was especially so where ownership of the sharescarried the right to occupy the property. In order to fulfil its purpose,paragraph 4 would have to apply whether the company was a residentof the Contracting State in which the immovable property was situatedor a resident of another State.

With regard to paragraph 5, a number of members considered thata Contracting State should have jurisdiction to tax the gain on the saleof shares of a company resident in that State whether the sale occurredwithin or outside the State but it was recognized that for administrativereasons the right to tax should be limited to a sale of substantial partici-pation. The determination of what was a substantial participation was leftto bilateral negotiations; for example, an agreed percentage of votingpower might be used to determine what constituted "substantial partici-pation".

The Group noted that some countries might consider that the Con-tracting State in which the company was resident should tax the aliena-tion of its shares only where a substantial portion of the assets weresituated in that State and in bilateral negotiations might urge such a limi-tation. Other countries might prefer that paragraph 5 be omitted entirely.

The Group noted further that some countries might feel it undesir-able to add to the situations mentioned in paragraphs 1, 2 and 3 onlythe situations mentioned in paragraphs 4 and 5, especially when theyconsidered that tax avoidance situations of special interest to them re-quired attention. Such countries might wish to replace paragraphs 4, 5and 6 of guideline 13 by the following paragraph:

"Gains from the alienation of any property other than thosegains mentioned in paragraphs 1, 2 and 3 shall be assessed andtaxed in accordance with the laws in force in either or both of theContracting States."

I. Independent personal services

Guideline 14

1. Income derived by a resident of a Contracting State in respectof professional services or other activities of an independent charactershall be taxable only in that State except in the following circumstances,when such income may also be taxed in the other Contracting State:

(a) If he has a fixed base regularly available to him in the otherContracting State for the purpose of performing his activities; in thatcase, only so much of the income as is attributable to that fixed base maybe taxed in that other Contracting State; or

80

(b) If his stay in the other Contracting State is for a period orperiods amounting to or exceeding in the aggregate 183 days in the fiscalyear concerned; or

(c) If the remuneration for his services in the other ContractingState derived from residents of that Contracting State exceeds in the fiscalyear an amount to be established through bilateral negotiations, notwith-standing the fact that his stay in that State is for a period or periodsamounting to less than 183 days during the fiscal year.

2. The term "professional services" includes especially indepen-dent scientific, literary, artistic, educational or teaching activities as wellas the independent activities of physicians, lawyers, engineers, architects,dentists and accountants.

ObservationsThe OECD Model Convention contains separate articles on inde-

pendent personal services (article 14) and dependent personal services(article 15). With regard to the former, the provisions of article 14 aresimilar to those of article 7 on business profits and are based on the sameprinciples. The OECD Model Convention would subject income derivedby an individual in respect of professional services or other activities ofan independent character to taxation in the source country only wherethe individual has a "fixed base" in that country for the purpose of per-forming his activities.

The Group of Experts agreed to recommend as a suggested text foran article in a bilateral tax treaty relating to the taxation of remunerationof independent personal services the text of article 14 of the OECDModel Convention with two substantive changes, namely, the inclusionof two additional exceptions to the basic principle that income derivedby a resident of a Contracting State in respect of professional servicesor other similar independent activities should be taxed only in that State.These two additional exceptions, relating to the length of stay in the sourcecountry and the amount of remuneration earned in that country are em-bodied in paragraph 1, subparagraphs (b) and (c), respectively, of guide-line 14; the exception originally provided for in article 14, paragraph 1,of the OECD Model Convention, relating to the maintenance of a fixedbase in the source country, is embodied in paragraph 1, subparagraph (a),of guideline 14. The commentary on article 14 of the OECD ModelConvention is relevant mutatis mutandis to guideline 14.

In the course of the discussion preceding the adoption of the guide-line some members from developing countries expressed the view that itwould not be justifiable to limit taxation by the source country by thecriteria of existence of a fixed base and length of stay, and that the sourceof income should be the only criterion. Some members from developedcountries, on the other hand, felt that the exportation of skills, like theexportation of tangible goods, should not give rise to taxation in thecountry of destination, unless the person concerned had a fixed base inthat country comparable to a permanent establishment; they thereforesupported the fixed base criterion. They also considered that taxation inthe source country would be justified by the continued presence in thatcountry of the person rendering the service. Some members from develop-ing countries also expressed support for the fixed base criterion.

81

Other members from developing countries expressed a preferencefor the length of stay criterion.

Several members from developing countries proposed a third criter-ion, namely, that of the amount of remuneration. Under that criterionremuneration for independent personal services could be taxed by thesource country if it exceeded a specified amount, regardless of the exis-tence of a fixed base or the length of stay in that country.

As a compromise, the Group decided to include all three criteriain guideline 14. With regard to the third criterion, embodied in subpara-graph (c), the Group was unable to reach a consensus on any specificamount and agreed that the matter shall be settled through bilateralnegotiations.

J. Dependent personal services

Guideline 15

1. Subject to the provisions of guidelines 16, 18 and 19, salaries,wages and other similar remuneration derived by a resident of a Con-tracting State in respect of an employment shall be taxable only in thatState unless the employment is exercised in the other Contracting State.If the employment is so exercised, such remuneration as is derived there-from may be taxed in that other State.

2. Notwithstanding the provisions of paragraph 1, remunerationderived by a resident of a Contracting State in respect of an employmentexercised in the other Contracting State shall be taxable only in the first-mentioned State if:

(a) The recipient is present in the other State for a period or pe-riods not exceeding in the aggregate 183 days in the fiscal year concerned;and

(b) The remuneration is paid by, or on behalf of, an employer whois not a resident of the other State; and

(c) The remuneration is not borne by a permanent establishmentor a fixed base which the employer has in the other State.

3. Notwithstanding the preceding provisions of this guideline re-muneration derived in respect of an employment exercised aboard a shipor aircraft operated in international traffic, or aboard a boat engaged ininland waterways transport, may be taxed in the Contracting State inwhich the place of effective management of the enterprise is situated.

Observations

The OECD Model Convention contains provisions concerning theremuneration of crews of ships or aircraft operated in international trafficor of boats engaged in inland waterways transport. These provisions fol-low to a certain extent the provisions of the OECD Model Conventionconcerning the income from shipping inland waterways transport and airtransport, since they make the remuneration of such crews taxable inthe Contracting State in which the place of effective management of theenterprise concerned is situated.

The 1965 report of the OECD Fiscal Committee mentioned earlier

82

contains the following considerations concerning dependent personalservices:

"The OECD draft convention provides for the taxation of in-come from dependent personal services in the country where theservices are performed. However, if the services involved are sup-plied by an employee of a foreign enterprise, he must be present inthe country for a period of six months or more before he becomestaxable. Such a rule, if used in conventions between developing andcapital exporting countries, may seem to favour the latter. Howeverit is important to note that skilled personnel are one of the greatneeds of developing countries'. Such persons are in demand every-where. If they are to become involved in the tax systems of develop-ing countries after relatively brief stays in such countries, it mayconstitute a barrier to their going to such countries. This has beenrecognized by the tax laws of some developing countries, and it isnot uncommon for them to grant exemption in such cases unilater-ally. It is conceivable that the personal service article will bearmodification, perhaps by lengthening the duration that a technicianmay remain in a host country without becoming subject to tax there.However, due consideration will have to be given to the desirabilityof permitting individuals to be wholly free of taxes."12

The Group of Experts agreed to recommend as a suggested textfor an article in a bilateral tax treaty relating to the taxation of remunera-tion of dependent personal services the text of article 15 of the OECDModel Convention. The whole of the commentary on the latter articleis therefore relevant to guideline 15.

K. Directors' fees and remuneration of top-level managerial officials

Guideline 16

Directors' fees and other similar payments derived by a resident ofa Contracting State in his capacity as a member of the Board of Directorsof a company which is a resident of the other Contracting State may betaxed in that other State. A similar rule shall apply to officials of a com-pany occupying top-level managerial positions with regard to paymentsreceived in that capacity from the company.

ObservationsThe OECD Model Convention contains a separate article on direc-

tors' fees which applies solely to payments received in the recipient'scapacity as a member of the Board of Directors of a company. The article,which is based on the assumption that it might sometimes be difficult toascertain where the services in question are performed, stipulates thatsuch payments may be taxed in the Contracting State of which the com-pany concerned is a resident.

Having considered the question of directors' fees, the Group of Ex-perts agreed to recommend as an article in a bilateral tax treaty relating

12 Organization for Economic Co-operation and Development, op. cit., para.175.

83

to the taxation of directors' fees and remuneration of top-level managerialofficials the text of article 16 of the OECD Model Convention, whichwould be supplemented by the addition of a second sentence dealing withpayments received by top-level managerial officials. The whole of thecommentary on article 16 is therefore relevant to guideline 16.

The Group observed that the top-level managerial positions of acompany resident in a Contracting State might be occupied by personsresident in the other Contracting State. In that situation the principleapplicable by the first Contracting State to the taxation of directors' feesshould also apply to the taxation of the remuneration paid to such top-level managerial officials. The term "top-level managerial positions" re-ferred to a limited group of positions that involved primary responsibilityfor the overall direction of the affairs of the company, apart from theactivities of the directors. The term would cover a person acting as botha director and a top-level manager.

L. Income earned by entertainers and athletes

Guideline 17

1. Notwithstanding the provisions of guidelines 14 and 15, incomederived by a resident of a Contracting State as an entertainer, such as atheatre, motion picture, radio or television artiste, or a musician, or asan athlete, from his personal activities as such exercised in the otherContracting State, may be taxed in that other State.

2. Where income in respect of personal activities exercised by anentertainer or an athlete in his capacity as such accrues not to the en-tertainer or athlete himself but to another person, that income may, not-withstanding the provisions of guidelines 7, 14 and 15, be taxed in theContracting State in which the activities of the entertainer or athlete areexercised.

Observations

The OECD Model Convention contains an article (article 17) whichcovers the activities of athletes as well as those of entertainers, and pro-vides that the activities of such persons shall be taxed in the State inwhich they are exercised. It may be noted that article 17 constitutes anexception to the rules laid down in article 14 of the OECD Model Con-vention on independent personal services, and paragraph 2 of article 15of that Convention on dependent personal services. Paragraph 2 of article17 is designed to help counter certain tax avoidance devices where theremuneration for the performance of an entertainer or athlete is paid,not to the entertainer or athlete himself, but to another person, e.g., aso-called artiste-company, in such a way that the income is taxed in theState where the activity is performed neither as personal service incomeof the entertainer or athlete nor as profit of the enterprise in the absenceof a permanent establishment.

The Group agreed to recommend as a suggested text for an articlein a bilateral tax treaty relating to the taxation of income earned by en-tertainers and athletes the text of article 17 of the OECD Model Con-vention. Consequently, the whole of the commentary on the latter article

84

is relevant to guideline 17. The Group furthermore agreed that the term"athlete", which, unlike the term "entertainer" was not followed in para-graph 1 by illustrative examples, was nevertheless likewise to be con-strued in a broad manner consistent with the spirit and the purpose ofthe guideline.

M. Pensions

Guideline 18A

Subject to the provisions of paragraph 2 of guideline 19, pensionsand other similar remuneration (but not including social security pay-ments) paid to a resident of a Contracting State in consideration of pastemployment shall be taxable only in that State.

Guideline 18B

1. Subject to the provisions of paragraph 2 of guideline 19, pen-sions and other similar remuneration (but not including social securitypayments) paid to a resident of a Contracting State in consideration ofpast employment, may be taxed in that State.

2. Notwithstanding the provisions of paragraph 1, such pensionsmay be taxed in the other Contracting State if the payment is made by aresident of that State or a permanent establishment situated therein.

Observations

The OECD Model Convention stipulates that private pensions andother similar remuneration paid to a resident of a Contracting State inconsideration of past employment shall be taxable only in that State.

During the discussion in the Group of Experts, several membersfrom developing countries expressed the view that pensions should not betaxed exclusively in the beneficiary's country of residence. They pointedout that since pensions were in substance a form of deferred compensa-tion for services performed in the source country, they should be taxedat source as normal employment income would be. They further observedthat pension flows between some developed and developing countrieswere not reciprocal and in some cases represented a relatively substantialnet outflow for the developing country. A number of members from de-veloping countries said they favoured exclusive taxation of pensions atsource but would be willing to grant an exemption from source taxationfor amounts equivalent to the personal exemptions allowable in the sourcecountry. Members from developed countries were generally of the viewthat pensions should be taxed only in the beneficiary's country of resi-dence. They suggested that since the amounts involved were generally notsubstantial developing countries would not suffer measurably if theyagreed to taxation in the country of residence. Those members also madethe point that the country of residence was probably in a better positionthan the source country to structure its taxation of pensions to the tax-payer's ability to pay.

A question was raised as to how pension payments would be taxedin the case of employees who had performed services consecutively inseveral different countries-a fairly common practice among employees

85

of transnational corporations. If such employees were taxed in each juris-diction in which they had previously worked to earn the pension, theneach pension payment might be taxed in a number of jurisdictions. It wasalso observed on the other hand that it would be very difficult for thehead office of a company to allocate each pension among the variouscountries in which the pensioner had worked during his years of employ-ment. It was generally agreed therefore that taxation of pension at sourceshould be construed to mean taxation at the place in which the pensionpayments originated, not the place where the services had been performed.

With respect to payments made under the social security schemesof Contracting States, most members felt that it would be preferable todeal with such payments in the provisions relating to remuneration inrespect of government services, that is, in guideline 19, rather than inthe provisions relating to pensions, that is, in guideline 18.

The Group was unable to reach a consensus that would have en-abled it to recommend a guideline suggesting the manner in which pensionpayments (but not including social security payments) should be taxed,that is, whether tax jurisdiction over such payments should be recognizedas belonging to the source country or the country of residence or to both.Hence the two alternatives suggested by the Group in guideline 18Aand guideline 18B respectively.

N. Remuneration in respect of government servicesand social security payments

Guideline 19

1. (a) Remuneration, other than a pension, paid by a Contract-ing State or a political subdivision or a local authority thereof to an in-dividual in respect of services rendered to that State or subdivision orauthority shall be taxable only in that State;

(b) However, such remuneration shall be taxable only in the otherContracting State if the services are rendered in that State and the indi-vidual is a resident of that State who:

(i) Is a national of that State; or(ii) Did not become a resident of that State solely for the purpose

of rendering the services.2. (a) Any pension shall be taxable only in the State making the

payment if:(i) It is paid by, or out of funds created by, a Contracting State

or a political subdivision or a local authority thereof to anindividual in respect of services rendered to that State or sub-division or authority; or

(ii) It is paid out under a public pension scheme which is part ofthe social security system of that State or a political subdivisionor local authority thereof;

(b) However, such pensions shall be taxable only in the otherContracting State if the individual is a resident of, and a national of, thatother State.

86

3. The provisions of guidelines 15, 16 and 18 shall apply to re-muneration and pensions in respect of services rendered in connexionwith a business carried on by a Contracting State or a political subdivisionor a local authority thereof.

Observations

The OECD Model Convention applies the source principle to re-muneration in respect of government services, for in the view of theOECD Committee on Fiscal Affairs such an approach is in conformitywith the rules of international courtesy and mutual respect between sov-ereign States and with the provisions of the Vienna Conventions onDiplomatic and Consular Relations.' 3 However, taking into account thefact that, as a result of the growth of the public sector in many countries,government activities abroad have been considerably extended, the OECDModel Convention applies the residence principle in the case of remuner-ation paid by one Contracting State to an individual in respect of servicesrendered in the other Contracting State if the individual is a resident ofthe latter State who is a national of that State or who did not become aresident of that State solely for the purpose of rendering the service.

The OECD Model Convention also applies the source principle inthe case of public pepsions, except for pensions paid by one ContractingState to individuals who are residents of, -and nationals of, the otherContracting State, which are taxable by the latter State. According tothe OECD Committee on Fiscal Affairs, this approach is likewise in keep-ing with the Vienna Conventions on Diplomatic and Consular Relations,according to which the receiving State is allowed to tax remuneration paidto certain categories of personnel of foreign diplomatic missions and con-sular posts who are permanent residents or nationals of that State.

It should be noted that neither article 19 nor article 18 of the OECDModel Convention refers specifically to pensions which are part of asocial security system. That omission is due to the fact that some Statesconsider such pensions to be similar to government pensions and there-fore liable to taxation under the source principle, while other States holdthe view that such pensions should be assimilated to private pensions andbe taxable only in the State of residence of the recipient. That being so,the Committee on Fiscal Affairs suggested in the Commentary on article18 that States advocating the application of the source principle mightseek in bilateral negotiations to include in the article modelled on article18 in their bilateral treaties a paragraph drafted along the following lines:"Notwithstanding the provisions of paragraph 1, pensions and other pay-ments made under the social security legislation of a Contracting Statemay be taxed in that State.""

After discussing the issues involved in the taxation of remunerationin respect of government service, the Group of Experts agreed to recom-mend as a suggested text for an article in a bilateral tax treaty relating tothe taxation of remuneration in respect of government services and social

13 Organization for Economic Co-operation and Development, Model DoubleTaxation Convention on Income and on Capital: Report of the Committee on Fis-cal Affairs (Paris, 1977), p. 138.

14 Ibid., p. 136.

87

security payments the text of article 19 of the OECD Model Conventionwith substantive adjustments in paragraph 2 necessitated by the Group'sprevious decision that social security payments should be dealt with inthe provisions relating to remuneration in respect of government services.Consequently the commentary on article 19 is relevant, mutatis mutandisto guideline 19.

The Group observed that while the provisions of the guideline weregenerally acceptable to its members, it felt that some developing coun-tries might in bilateral negotiations desire to limit by reference to-a ceilingamount the restriction in paragraph 2 (b) on the taxation of pensions bythe Government making the pension payments where the recipient is aresident or a national of another country. The Group also felt that somedeveloping countries might prefer that payments dealt with in guideline19 should be taxed only by the beneficiary's country of residence.

0. Payments received by students and apprentices

Guideline 20

1. Payments which a student or business apprentice, who is or wasimmediately before visiting a Contracting State a resident of the otherContracting State and who is present in the first-mentioned State solelyfor the purpose of his education or training, receives for the purpose ofhis maintenance, education or training shall not be taxed in that State,provided that such payments arise from sources outside that State.

2. In respect to grants, scholarships and remuneration from em-ployment not covered by paragraph 1, a student or business apprenticedescribed in paragraph 1 shall, in addition, be entitled during such edu-cation or training to the same exemptions, reliefs or reductions in respectof taxes available to residents of the State which he is visiting.

Observations

The OECD Model Convention provides that payments received bystudents or business apprentices for the purpose of their maintenance,education or training and from sources outside the State in which thestudent or business apprentice concerned is staying shall be exemptedfrom tax in that State. This provision, however, does not cover a personwho has once been a resident of a Contracting State but has subsequentlymoved his residence to a third State before visiting the other ContractingState.

After discussing the question of the taxation of students, the Groupof Experts agreed to recommend as a suggested text for an article in abilateral tax treaty relating to the taxation of payments received by stu-dents and apprentices the text of article 20 of the OECD Model Conven-tion, which would be supplemented by the addition of a second paragraphdealing with grants and scholarships and remuneration from employmentnot covered by paragraph 1. Consequently, the commentary on article20 is relevant mutatis mutandis to guideline 20.

Some members of the Group felt that students or business appren-tices should be exempted from tax on income received from employmentin the Contracting State which they were visiting during their period of

88

study or training. However it was recognized that this exemption couldin some situations be regarded as discriminatory against local studentsor business apprentices receiving employment income. The limited ap-proach suggested in paragraph 2 would eliminate any possible discrimi-nation. It was observed that some countries in bilateral negotiations mightwish to expand the guideline by adding a paragraph permitting a furtherexemption (beyond that generally applicable as a personal exemption orsimilar allowance under the internal law of the Contracting State) ofemployment income under certain conditions, either by limiting the rele-vant amount of income or by confining the exemption to amounts re-quired for maintenance and support. In limiting the amount, somecountries might wish to utilize as a guide the additional costs incurredas a result of the fact that the students or business apprentices were visi-tors. If such further exemption were to be permitted it would be appro-priate in the case of business apprentices to place a time-limit on theexemption, and also perhaps in the case of students, with a longer periodpresumably allowed in the latter situation.

P. Other income

Guideline 21

1. Items of income of a resident of a Contracting State, whereverarising, not dealt with in the foregoing guidelines shall be taxable onlyin that State.

2. The provisions of paragraph 1 shall not apply to income, otherthan income from immovable property as defined in paragraph 2 ofguideline 6, if the recipient of such income, being a resident of a Contrac-ting State, carries on business in the other Contracting State through apermanent establishment situated therein, or performs in that other Stateindependent personal services from a fixed base situated therein, and theright or property in respect of which the income is paid is effectivelyconnected with such permanent establishment or fixed base. In such casethe provisions of guideline 7 or guideline 14, as the case may be, shallapply.

3. Notwithstanding the provisions of paragraphs 1 and 2, itemsof income of a resident of a Contracting State not dealt with in the fore-going guidelines, and arising in the other Contracting State may be taxedin that other State.

Observations

The OECD Model Convention contains a separate article (article21) on "other income". The commentary on that article states that theincome concerned is not only income of a class not expressly dealt withbut also income from sources not expressly mentioned; the commentaryalso notes that the scope of the article is not confined to income arisingin a Contracting State but extends also to income from third States.

The OECD Model Convention, assigns the exclusive right to tax"other income" to the State of residence of the recipient. In cases of con-flict between two residencies, the provisions of article 4 on "resident" willapply in the case of income received from third States. An exception to

89

the application of the residence principle is provided for in cases wherethe income is associated with the activity of a permanent establishmentor fixed base which a resident of a Contracting State has in the otherContracting State. In such cases, a right to tax is given to the ContractingState in which the permanent establishment or fixed base is situated.

The Group of Experts agreed to recommend as a suggested textfor an article in a bilateral tax treaty relating to the taxation of incomeother than that covered in the preceding guidelines the text of article 21of the OECD Model Convention with one substantive change which altersthe thrust of the OECD article, namely, the addition of a new paragraph(paragraph 3) providing a general rule relating to items of income of aresident of a Contracting State not dealt with in the preceding guidelinesand arising in the other Contracting State. Consequently the commentaryon article 21 is relevant mutatis mutandis to guideline 21.

The Group observed that the provisions of paragraph 3 would per-mit the country in which the income arises to tax such income if its lawso provides while the provisions of paragraph 1 would permit taxationin the country of residence; the concurrent application of the provisionscontained in the two paragraphs might result in double taxation. In sucha situation, the provisions of guidelines 23A or 23B as appropriate wouldbe applicable, as in other cases of double taxation. The Group furtherobserved that in some cases paragraphs 2 and 3 might overlap and that insuch cases they produce the same result.

CHAPTER IV

TAXATION OF CAPITAL

Guideline 22

[The Group decided to leave to bilateral negotiations the questionof the taxation of the capital represented by immovable property andmovable property and of all other elements of capital of a resident of aContracting State.]

Observations

The Group emphasized that its decision to leave the question ofthe taxation of capital to bilateral negotiations should not be construedas indicating a position of principle with regard to the desirability of suchtaxation. The Group's decision is irrelevant in the case of countries whichhave not deemed it necessary to levy taxes on capital.

90

CHAPTER V

METHODS FOR ELIMINATION OF DOUBLE TAXATION

A. Exemption method

Guideline 23A1. Where a resident of a Contracting State derives income or owns

capital which, in accordance with the provisions of the treaty, may betaxed in the other Contracting State, the first-mentioned State shall,subject to the provisions of paragraphs 2 and 3, exempt such income orcapital from tax.

2. Where a resident of a Contracting State derives items of incomewhich, in accordance with the provisions of guidelines 10 and 11, maybe taxed in the other Contracting State, the first-mentioned State shallallow as a deduction from the tax on the income of that resident anamount equal to the tax paid in that other State. Such deduction shallnot, however, exceed that part of the tax, as computed before the deduc-tion is given, which is attributable to such items of income derived fromthat other State.

3. Where in accordance with any provision of the treaty incomederived or capital owned by a resident of a Contracting State is exemptfrom tax in that State, such State may nevertheless, in calculating theamount of tax on the remaining income or capital of such resident, takeinto account the exempted income or capital.

B. Credit methodGuideline 23B

1. Where a resident of a Contracting State derives income or ownscapital which, in accordance with the provisions of the treaty, may betaxed in the other Contracting State, the first-mentioned State shouldallow:

(a) As a deduction from the tax on the income of that resident, anamount equal to the income tax paid in that other State;

(b) As a deduction from the tax on the capital of that resident, anamount equal to the capital tax paid in that other State.Such deduction in either case shall not, however, exceed that part of theincome tax or capital tax, as computed before the deduction is given,which is attributable, as the case may be, to the income or the capitalwhich may be taxed in that other State.

2. Where in accordance with any provision of the treaty incomederived or capital owned by a resident of a Contracting State is exemptfrom tax in that State, such State may nevertheless, in calculating theamount of tax on the remaining income or capital of such resident, takeinto account the exempted income or capital.

[N.B.The references to capital in guidelines 23A and 23B are to be

disregarded if the treaty is not to include an article on the taxation ofcapital. In this connexion, see the observation on guideline 22.]

91

Observations

The Group of Experts agreed to recommend as suggested texts forarticles in a bilateral tax treaty relating to the methods for the eliminationof double taxation the texts of articles 23A and 23B of the OECD ModelConvention. Guidelines 23A and 23B therefore reproduce the texts ofthose articles. Consequently the whole of the commentary on those articlesis relevant to guidelines 23A and 23B.

The Group agreed that, generally speaking, the method by whicha country would give relief from double taxation depended primarily onits general tax policy and the structure of its tax system. Owing to thedifferences which existed in the various tax systems as regards the ob-jectives pursued, it was further agreed that bilateral tax treaties providedthe most flexible instrument for reconciling conflicting tax systems andfor the avoidance or mitigation of double taxation.

Members from developing countries felt that, as regards relief meas-ures to be applied by developed countries, the methods of tax exemption,tax credit (including tax-sparing credit) and investment credit could beused as appropriate. The exemption method was considered eminentlysuitable where exclusive tax jurisdiction over certain income was allottedto the country of source under a treaty; it might take therein the form ofan exemption with progression. Where the investor's home country ap-plied the principle of foreign tax credit, the most effective method ofpreserving the effect of the tax incentives and concessions extended bydeveloping countries would be the application of a tax-sparing creditin addition to the regular tax credit. Otherwise, under certain circum-stances the benefits would accrue to the treasury of the developed coun-try rather than to the investor for whom they were designed.

CHAPTER VI

SPECIAL PROVISIONS

A. Non-discrimination

Guideline 241. Nationals of a Contracting State shall not be subjected in the

other Contracting State to any taxation or any requirement connectedtherewith, which is other or more burdensome than the taxation and con-nected requirements to which nationals of that other State in the samecircumstances are or may be subjected. This provision shall, notwith-standing the provisions of guideline 1, also apply to persons who are notresidents of one or both of the Contracting States.

2. The term "nationals" means:(a) All individuals possessing the nationality of a Contracting

State;(b) All legal persons, partnerships and associations deriving their

status as such from the laws in force in a Contracting State.

92

3. Stateless persons who are residents of a Contracting State shallnot be subjected in either Contracting State to any taxation or any re-quirement connected therewith, which is other or more burdensome thanthe taxation and connected requirements to which nationals of the Stateconcerned in the same circumstances are or may be subjected.

4. The taxation on a permanent establishment which an enterpriseof a Contracting State has in the other Contracting State shall not be lessfavourably levied in that other State than the taxation levied on enterprisesof that other State carrying on the same activities. This provision shallnot be construed as obliging a Contracting State to grant to residents ofthe other Contracting State any personal allowances, reliefs and reduc-tions for taxation purposes on account of civil status or family respon-sibilities which it grants to its own residents.

5. Except where the provisions of paragraph 1 of guideline 9,paragraph 6 of guideline 11, or paragraph 6 of guideline 12, apply, in-terest, royalties and other disbursements paid by an enterprise of a Con-tracting State to a resident of the other Contracting State shall for thepurpose of determining the taxable profits of such enterprise, be deduct-ible under the same conditions as if they had been paid to a resident ofthe first-mentioned State. Similarly, any debts of an enterprise of a Con-tracting State to a resident of the other Contracting State shall for thepurpose of determining the taxable capital of such enterprise, be deduct-ible under the same conditions as if they had been contracted to a residentof the first-mentioned State.

6. Enterprises of a Contracting State, the capital of which is whollyor partly owned or controlled, directly or indirectly, by one or moreresidents of the other Contracting State, shall not be subjected in thefirst-mentioned State to any taxation or any requirement connectedtherewith which is other or more burdensome than the taxation andconnected requirements to which other similar enterprises of the first-mentioned State are or may be subjected.

7. The provisions of this guideline shall, notwithstanding the pro-visions of guideline 2, apply to taxes of every kind and description.

ObservationsThe OECD Model Convention contains provisions in article 24 on

non-discrimination, which establish the principle that for purposes oftaxation, discrimination on the grounds of nationality is forbidden andthat subject to reciprocity the nationals of a Contracting State may notbe less favourably treated in the other Contracting State than nationals ofthe latter State in the same circumstances.

It may be recalled that long before the emergence of the classicaltype of double taxation treaty at the end of the nineteenth century, theprinciple of non-discrimination in fiscal matters had been embodied inmany different types of international agreements under which each Con-tracting State undertook to grant nationals of the other Contracting Statethe same treatment as its own nationals (consular or establishment con-ventions, treaties of friendship or commerce etc.). In view of the long-standing acceptance of the principle of non-discrimination in internationalfiscal relations, which in the twentieth century has been included invirtually all bilateral treaties for the avoidance* of double taxation, the

93

Group had no difficulty in agreeing that the principle should be embodiedin the guidelines.

The Group therefore agreed to recommend as a suggested text foran article in a bilateral tax treaty relating to non-discrimination the textof article 24 of the OECD Model Convention. Consequently the wholeof the commentary on the latter article is relevant to guideline 24.

A question was raised as to whether paragraph 5 of that article wassuitable for inclusion in a tax treaty between developed and developingcountries. It was suggested that that paragraph would not be acceptable tothose countries that made deductibility of disbursements made abroadby foreign-owned corporations conditional on the recipient being taxed insuch countries. After substantial discussion, the feeling of the Group wasthat the special circumstances mentioned above ought not to be the basisfor treaty guidelines of broad application but that in cases where theywere likely to create a problem they should be raised in bilateralnegotiations.

A member from a developing country proposed that special measuresapplicable to foreign-owned enterprises should not be construed as con-stituting prohibited discrimination as long as all foreign-owned enterpriseswere treated alike; he said that that change represented a notable de-parture from the general principle of taxing foreign persons on the samebasis as nationals but that the problems of tax compliance in cases inwhich foreign ownership was involved and the politically sensitiveposition of foreign-owned enterprises in developing countries warrantedthe change. Therefore, he proposed that paragraph 6 of article 24 of theOECD Model Convention be amended to read as follows:

"6. Enterprises of a Contracting State, the capital of whichis wholly or partly owned or controlled, directly or indirectly, byone or more residents of the other Contracting State, shall not besubjected in the first-mentioned State to any taxation or any require-ment connected therewith which is other or more burdensome thanthe taxation and connected requirements to which are subjectedother similar enterprises the capital of which is wholly or partlyowned or controlled, directly or indirectly, by residents of thirdcountries."

He went on to point out that the proposed change in paragraph 6 hadbeen included in several tax treaties to which developed countries wereparties. Some members from developed countries pointed out that such aproposal would in fact limit the effect of the non-discrimination articleto the prevention of discrimination between enterprises owned by non-residents, thus leaving the door open to discrimination against enterprisesowned by non-residents as a class.

Several members from developed countries expressed reservationsconcerning the proposed change and pointed out that they considered theOECD non-discrimination article as the backbone of the Convention.They recalled that the antecedents of the non-discrimination article inthe present OECD Model Convention dated from the nineteenth century.They felt that if such a fundamental principle were to be altered, it wouldhave a significant effect on international tax relations generally. Further,

94

since the proposed change was motivated in part by problems with taxcompliance where foreign ownership was involved-essentially, problemswith transfer pricing-it was suggested that the problem might be dealtwith more properly in other parts of the tax convention, such as inarticle 9 dealing with associated enterprises.

Some members indicated that, while recognizing the essential im-portance of and need for the guideline on non-discrimination, some coun-tries might wish to modify certain paragraphs of that guideline in bilateralnegotiations. It was suggested, for example, that because of the difficultiesinvolved in determining what constituted reasonable amounts in the caseof transfer payments on account of royalties, technical assistance fees andso on, a country might desire to deny deductions for such payments whenmade by an enterprise situated within its territory to a foreign controllingcompany, whether the latter was resident in another Contracting State orin a third country. Another example cited was that of a country whichgranted tax preferences with a view to the attainment of certain nationalobjectives which might wish to make a given percentage of local owner-ship of the enterprise involved a condition for the granting of such taxpreferences. The Group recognized that special situations such as thosementioned as examples should be resolved in bilateral negotiations.

B. Mutual agreement procedure

Guideline 25

1. Where a person considers that the actions of one or both of theContracting States result or will result for him in taxation not in accord-ance with the provisions of the treaty, he may, irrespective of the reme-dies provided by the domestic law of those States, present his case to thecompetent authority of the Contracting State of which he is a residentor, if his case comes under paragraph 1 of guideline 24, to that of theContracting State of which he is a national.

2. The competent authority shall endeavour, if the objection ap-pears to it to be justified and if it is not itself able to arrive at a satisfactorysolution, to resolve the case by mutual agreement with the competentauthority of the other Contracting State, with a view to the avoidance oftaxation which is not in accordance with the treaty. Any agreementreached shall be implemented notwithstanding any time-limits in thedomestic law of the Contracting States.

3. The competent authorities of the Contracting States shall en-deavour to resolve by mutual agreement any difficulties or doubts arisingas to the interpretation or application of the treaty. They may also consulttogether for the elimination of double taxation in cases not provided forin the treaty.

4. The competent authorities of the Contracting States may com-municate with each other directly for the purpose of reaching an agree-ment in the sense of the preceding paragraphs. The competent authorities,through consultations, shall develop appropriate bilateral procedures,conditions, methods and techniques for the implementation of the mutualagreement procedure provided in this guideline. In addition, a competentauthority may devise appropriate unilateral procedures, conditions,

95

methods and techniques to facilitate the above-mentioned bilateral ac-tions and the implementation of the mutual agreement procedure.

5. The mutual agreement procedure shall apply in connexion withaction taken within the context of guidelines 7, 9, 11, 12 and 23.

ObservationsDifficulties of interpretation or application are likely to occur in

connexion with the implementation of a bilateral tax treaty, as in con-nexion with the implementation of any treaty. These difficulties mightimpair or impede the normal operation of the provisions of the treatyas originally conceived by the negotiating parties. Hence the need for amutual agreement procedure for resolving any disagreement arising outof the implementation of the treaty in the broadest sense of the term.Such a mutual agreement procedure is clearly a special procedure outsidethe legal and judicial system of each Contracting State.

The OECD Model Convention sets forth in article 25 a mutualagreement procedure for resolving difficulties arising out of the applica-tion of the Convention in the broadest sense of the term. Under such aprocedure, the competent authorities of the two Contracting States areto endeavour by mutual agreement to resolve the situation of taxpayerssubjected to taxation not in accordance with the provisions of the Con-vention. They are also invited and authorized to resolve by mutual agree-ment problems relating to the interpretation or application of the Con-vention and, furthermore, to consult together for the elimination of doubletaxation in cases not provided for in the Convention. Concerning thepractical operation of the mutual agreement procedure, the competentauthorities are merely authorized to communicate with each other di-rectly, without going through diplomatic channels, and, if it seems ad-visable to them, to have an oral exchange of opinion through a jointcommission appointed especially for the purpose.

The commentary on article 25 states that in practice the mutualagreement procedure "applies to cases-by far the most numerous-where the measure in question leads to double taxation which it is thespecific purpose of the Convention to avoid. Among the most commoncases, mention must be made of the following:

"The question relating to attribution to a permanent establish-ment of a proportion of the executive and general administrativeexpenses incurred by the enterprise, under paragraph 3 of article 7;

"The taxation in the State of the payer-in case of a specialrelationship between the payer and the beneficial owner-of theexcess part of interest and royalties, under the provisions of article9, paragraph 6 of article 11 or paragraph 4 of article 12;

"Cases where lack of information as to the taxpayer's actualsituation has led to misapplication of the Convention, especially inregard to the determination of residence (paragraph 2 of article 4),the existence of a permanent establishment (article 5), or the tempo-rary nature of the services performed by an employee (paragraph 2of article 15)".15

15 Ibid., p. 176.

96

The commentary also notes that "on the whole the mutual agree-ment procedure has proved satisfactory" and that "the most recenttreaty practice shows that article 25 represents the maximum that Con-tracting States are prepared to accept". The Commentary adds that itmust however be admitted that the procedure "is not yet entirely satis-factory from the taxpayer's viewpoint . .. because the competent au-thorities are required only to seek a solution and are not obliged tofind one". 16

In the light of the foregoing and in view of the need to provide fora mutual agreement procedure, the Group of Experts decided to recom-mend as a suggested text of an article in a bilateral tax treaty relating tosuch procedure the text of article 25 of the OECD Model Conventionwith three substantive changes, namely the deletion of the last sentenceof paragraph 1, the deletion of the second sentence of paragraph 4 ofarticle 25 of the Convention and its replacement by the second and thirdsentences of paragraph 4 of guideline 25 and the addition of a new para-graph 5. The commentary on article 25 of the OECD Model Conventionis relevant mutatis mutandis to guideline 25. According to the Group, theprocedure is designed not only to provide a means of settling questionsrelating to the interpretation and application of the treaty, but also toprovide a forum in whicn residents of the States involved can protestactions not in accordance with the treaty and a mechanism for eliminatingdouble taxation in cases not provided for in the treaty. It is clear fromthe wording of guideline 25 that the mutual agreement procedure extendsto the matters dealt with in guideline 7 on business profits and guideline9 on associated enterprises and to other guidelines involving allocationsuch as guideline 23 on methods for the elimination of double taxationand guidelines providing for the treatment of certain expenses in thesource country (e.g., guidelines 11 and 12).

With regard to paragraph 4 of guideline 25, the Group emphasizedthe following essential elements in respect of income and expense alloca-tions, including transfer pricing:

Transactions between related entities should be governed bythe standard of "arm's length dealing". As a consequence, if anactual allocation is considered by the tax authorities of a treatycountry to depart from that standard the taxable profits may beredetermined;

Taxpayers are entitled to invoke the mutual agreement pro-cedure where they consider that such action by one or both of thetax authorities regarding such redetermination is contrary to thearm's length standard;

The implementation of the mutual agreement procedure isdelegated to the competent authorities of the treaty countries, withadequate powers to ensure full implementation and with the ex-pectation that such implementation will enable the mutual agreementprocedure to be an effective instrument for carrying out the purposeof the treaty. The Group stressed that such delegation included theestablishment of time limits within which matters should be pre-

16 ibid., p. 182.

97

sented by the interested parties to the appropriate competent au-thority, and hence made unnecessary the last sentence of para-graph 1 of OECD article 25 dealing with that aspect.[N.B.For more detailed suggestions on procedural and substantive aspects

of the mutual agreement procedure see part three, chaps. I and II.]

C. Exchange of information

Guideline 261. The competent authorities of the Contracting States shall ex-

change such information as is necessary for carrying out the provisionsof the treaty or of the domestic laws of the Contracting States concerningtaxes covered by the treaty, in so far as the taxation thereunder is notcontrary to the treaty, in particular for the prevention of fraud or evasionof such taxes. The exchange of information is not restricted by guide-line 1. Any information received by a Contracting State shall be treatedas secret in the same manner as information obtained under the domesticlaws of that State. However, if the information is originally regarded assecret in the transmitting State it shall be disclosed only to persons orauthorities (including courts and administrative bodies) involved in theassessment or collection of, the enforcement or prosecution in respectof, or the determination of appeals in relation to, the taxes which arethe subject of the treaty. Such persons or authorities shall use the infor-mation only for such purposes but may disclose the information in publiccourt proceedings or in judicial decisions. The competent authoritiesshall, through consultation, develop appropriate conditions, methods andtechniques concerning the matters in respect of which such exchangesof information shall be made, including, where appropriate, exchanges ofinformation regarding tax avoidance.

2. In no case shall the provisions of paragraph 1 be construed soas to impose on a Contracting State the obligation:

(a) To carry out administrative measures at variance with the lawsand administrative practice of that or of the other Contracting State;

(b) To supply information which is not obtainable under the lawsor in the normal course of the administration of that or of the other Con-tracting State;

(c) To supply information which would disclose any trade, busi-ness, industrial, commercial or professional secret or trade process, orinformation, the disclosure of which would be contrary to public policy(ordre public).

ObservationsThe aim of double taxation treaties is to promote international

movements of capital and persons through the elimination of internationaldouble taxation without creating loop-holes permitting increased taxevasion. The issue of tax evasion, although obviously important to devel-oped countries, is even more important to developing countries. Experi-ence has shown quite clearly that a tax administration which relies onlyon the information available to it within its national jurisdiction is not

98

equipped to deal effectively with the problems posed by tax evasion. Theprovisions of a tax treaty between a developing and a developed countryproviding either for taxation on a net basis or for taxation on a grossbasis with the result to approximate that arrived at on a net basis maynot be applicable to any meaningful extent if the developing country can-not obtain access to reliable outside information within a reasonableperiod of time. There is thus a strong rationale for the inclusion in abilateral tax treaty for the avoidance of double taxation of provisionsconcerning co-operation between the Contracting States with respect tothe supply of information necessary to ensure the correct enforcementof the provisions of the treaty or of the domestic laws of the ContractingStates concerning taxes covered by the treaty.

The OECD Model Convention deals with the subject in article 26which provides for the exchange of information concerning taxes coveredby the Convention as is necessary for carrying out the provisions of theConvention or of the domestic laws of the Contracting States; the ex-change of information is not restricted by article 1 of the Convention, sothat the information may include particulars about non-residents.

The information obtained may be disclosed only to persons andauthorities involved in the assessment or collection of, the enforcementor prosecution in respect of, or the determination of appeals in relationto, the taxes covered by the Convention. A Contracting State is not boundto go beyond its own internal laws and administrative practice in puttinginformation at the disposal of the other Contracting State. Information isdeemed to be obtainable in the normal course of administration if it is inthe possession of the tax authorities or can be obtained by them in thenormal procedure of tax determination, which may include special in-vestigations or special examination of the business accounts kept by thetaxpayer or other persons, provided that the tax authorities would makesimilar investigations or examination for their own purposes. ContractingStates do not have to supply information the disclosure of which wouldbe contrary to public policy.

In this connexion mention may be made of the Convention onAdministrative Assistance in Tax Matters concluded by the Nordic coun-tries, which contains detailed provisions on the exchange of information.It is to be recalled that the Multilateral Convention is divided into fiveparts, the most essential of which are those concerning the procurementof information and tax enforcement. The Convention also containsgeneral provisions, provisions concerning the service of documents andspecial provisions. In addition to the income and capital taxes dealt within the conventions for the avoidance of double taxation between theNordic countries, the Multilateral Convention covers inheritance or estatetaxes, gift tax, certain indirect taxes (such as motor vehicle taxes andvalue added taxes), social security and some other public charges andadvance payments of taxes. The Multilateral Convention originally pro-vided that the assistance could take the form of tax collection and en-forcement, service of documents and exchange of information, eitherautomatically or on request. The 1976 Additional Agreement extendedthe scope of the exchange of information system to cover the spontaneousexchange of information. It also made it possible for tax officials of one

99

Nordic country to take part in tax investigations in another Nordic coun-try if the tax matter is of a substantial interest to that former country.

Under that Convention, requests for assistance (including the pro-vision of information) cannot be made unless the requesting State inaccordance with its own legislation would be able to provide corre-sponding assistance at the request of the requesting State. Informationmust be processed in accordance with the legislation of the requestedState and requests for procurement of information may be refused wherea business, manufacturing or professional secret would be disclosed ifthe request were complied with. Representatives of the tax authority of aContracting State may, if a tax matter is of substantial interest to thatState, be allowed at the request of the competent authority of that State,to be present at an investigation of such a tax matter in another Contract-ing State. Information revealed in the course of the investigation is tobe treated as secret and must not be disclosed to persons or authoritiesincluding courts and other judicial authorities, other than those concernedwith the assessment or collection of, the enforcement or prosecution inrespect of, or the determination of appeals in relation to the taxes whichare the subject of the Convention. The competent authority is required,in so far as it is possible on the basis of available statements of income orsimilar information, send to the competent authorities in each of theother Contracting State, as soon as possible after the end of each calendaryear and without being specially requested to do so, information con-cerning individuals and legal persons resident in that State regarding:

(a) Dividends paid by joint stock companies and similar legalpersons;

(b) Interest on bonds and similar securities;(c) Balances with banks, savings banks and similar institutions

and interest on such balances;(d) Royalties and other charges paid periodically for the utilization

of copyrights, patents, designs, trade marks or other such rights orproperty;

(e) Wages, salaries, fees, pensions and annuities;(f) Damages, insurance payments and other similar compensation

obtained in connexion with trade or business activities; and(g) Other income or property to the extent set out in a further

agreement which may be concluded between the competent authoritiesof the Contracting State for the implementation of the Convention.

The Group of Experts considered that the exchange of informationconstituted a valuable means of preventing tax evasion. In that perspec-tive, and after examining the approaches taken in the various modelconventions, the Group agreed to recommend as guideline 26 the pro-visions of article 26 of the OECD Model Convention with three sub-stantive changes in paragraph 1, namely, the insertion of the phrase "andin particular for the prevention of fraud or evasion of such taxes" inthe first sentence, the insertion of the phrase "and where originally re-garded as secret in the transmitting State" in the third sentence and theaddition of a new sentence (sixth and last sentence). The latter sentenceis the key to the approach advocated by the Group; it would obligate the

100

competent authorities to implement fully the provisions on the exchangeof information.

The Group observed that the reference to fraud or evasion in para-graph 1 was intended to focus attention on the importance of exchangesof information that would assist the treaty partners in combating suchpractices. Since a number of countries were concerned with the need forinformation to assist in the administration of specific statutory provisionsagainst tax avoidance and others were concerned with the need for infor-mation to assist in detecting other aspects of tax avoidance, the Groupconsidered it advisable to include the reference in the last sentence ofparagraph 1 to exchanges of information regarding tax avoidance wherethe treaty partners deemed it appropriate. The reference in the samesentence to the consultations aimed at developing appropriate conditions,methods and techniques was designed to enable the treaty partners towork out the modalities for exchanges of information between them.

During the course of the discussion members from developing coun-tries observed that the proliferation of transnational corporations and theever-growing sophistication and complexity of the forms taken by inter-national business transactions was resulting in increasing tax avoidanceand evasion. The view was expressed that such a situation might havereached a point where it might negate completely the effects of treatiesfor the avoidance of double taxation and raised the question whethersteps should be taken outside and in addition to the existing frameworkof such treaties. One member from a developing country, supported byother members from developing countries, suggested that the quickest andmost effective way of ensuring the exchange of information required tocombat tax evasion efficiently would be through the conclusion of amultilateral agreement dealing specifically with the exchange of informa-tion and mutual assistance in tax administration.

While discussing the problems of tax havens, the Group felt that as aprotection against improper manipulation of treaty benefits, considerationshould be given in bilateral negotiations to the inclusion of a separatearticle along the following lines:

"Each of the Contracting States should endeavour to collecton behalf of the other Contracting State such taxes imposed by thatother Contracting State to the extent necessary to ensure that anyexemption or reduced rate of tax granted under the treaty by thatother Contracting State should not be enjoyed by persons not entitledto such benefits."[N.B.For further discussion of the question of the exchange of informa-

tion, see part three, chap. III.]

E. Diplomatic agents and consular officers

Guideline 27

Nothing in the treaty shall affect the fiscal privileges of diplomaticagents or consular officers under the general rules of international law orunder the provisions of special agreements.

101

ObservationsThe Group of Experts agreed to recommend as a suggested text

for an article in a bilateral tax treaty relating to diplomatic agents andconsular officers the text of article 27 of the OECD Model Convention.Consequently the whole of the commentary on the latter article is relevantto guideline 27.

CHAPTER VII

FINAL PROVISIONS

A. Entry into force

Guideline 281. This treaty shall be ratified and the instruments of ratification

shall be exchanged at ...... as soon as possible.2. The treaty shall enter into force upon the exchange of instru-

ments of ratification and its provisions shall have effect:(a) (in State A):....................................(b) (in State B):....................................

B. Termination

Guideline 29This treaty shall remain in force until terminated by a Contracting

State. Either Contracting State may terminate the treaty through thediplomatic channels, by giving notice of termination at least six monthsbefore the end of any calendar year after the year ....... In such event,the treaty shall cease to have effect:

(a) (in State A):....................................(b) (in State B):....................................

Observations on guidelines 28 and 29The Group of Experts agreed to recommend as a suggested text for

articles in a bilateral tax treaty relating to the entry into force and termi-nation of the treaty the texts of articles 29 and 30 of the OECD ModelConvention. The whole of the commentary on those articles is thereforerelevant to guidelines 28 and 29.

Terminal clause

[N.B.The provisions relating to the entry into force and termination and

the terminal clause concerning the signing of the treaty shall be drafted inaccordance with the constitutional procedure of both Contracting States.]

102

Part Three

SUGGESTIONS RELATING TO THEAPPLICATION OF THE GUIDELINES

AND TO PROCEDURAL ASPECTSOF TAX TREATY NEGOTIATIONS

I. PROCEDURAL ASPECTS OF MUTUAL AGREE-MENT PROCEDURE PROVIDED FOR IN GUIDE-LINE 25

In order to assist the competent authorities in applying the mutualagreement procedure provided for in guideline 25, a number of possiblearrangements are described below and certain factors relevant to theiruse discussed. This enumeration of arrangements is not intended to beexhaustive and can be extended as appropriate in the light of experience.

A. GENERAL CONSIDERATIONS

The procedural arrangements should be suitable to the number andtypes of issues expected to be dealt with by the competent authoritiesand to the administrative capability and resources of those authorities.The arrangements should not be rigidly structured but instead shouldembody the degree of flexibility required to facilitate consultation andagreement rather than hinder them by elaborate procedural requirementsand mechanisms. But even relatively simple procedural arrangementsmust incorporate certain minimum rules that inform taxpayers of theiressential rights and obligations under the mutual agreement procedure.Such minimum rules would appear to involve such questions as:

At what stage in his tax matter can a taxpayer invoke action by thecompetent authority under the mutual agreement procedure?

Must any particular form be followed by a taxpayer in invokingaction by the competent authority?

Are there time-limits applicable to a taxpayer's invocation of actionby the competent authority?

If a taxpayer invokes action by the competent authority, is he boundby the decision of the competent authorities and must he waive recourseto other administrative or judicial processes?

In what manner, if at all, can a taxpayer participate in the com-petent authority proceedings? What requirements regarding the furnish-ing of information by a taxpayer are involved?

B. INFORMATION ON ADJUSTMENTS

The competent authorities should decide on the extent of the infor-mation to be provided on adjustments involving income allocation andthe time when it is to be given by one competent authority to the other.Thus, the information could cover adjustments proposed or concludedby the tax administration of one country, the related entities involvedand the general nature of the adjustments.

Generally speaking, most competent authorities are likely to con-clude that the automatic transmittal of such information is not needed

105

or desirable. The competent authority of the country making an adjust-ment may find it difficult or time-consuming to gather the informationand prepare it in a suitable form for transmission. In addition, the othercompetent authority may find it burdensome merely to process a volumeof data routinely transmitted by the first competent authority. Moreover,a taxpaying corporation can usually be counted upon to inform its relatedentity in the other country of the proceedings and the latter is thus in aposition to inform, in turn, its competent authority. For this reason, thefunctioning of a consultation system would be aided if a tax administra-tion considering an adjustment possibly involving an international aspectwould give the taxpayer warning as early as possible.

Some competent authorities, while not desiring to be informed rou-tinely of all adjustments in the other country, may desire to receive, eitherfrom their own taxpayers or from the other competent authority, "earlywarning" of serious cases or of the existence of a significant degree orpattern of activity respecting particular types of cases; similarly, theymay want to transmit such information. In this event, a process shouldbe worked out for obtaining this information. Some competent authoritiesmay want to extend this early warning system to less serious cases, thuscovering a larger number of cases.

C. INVOCATION OF COMPETENT AUTHORITY CONSULTATION ATPOINT OF PROPOSED OR CONCLUDED ADJUSTMENTS

The competent authorities must decide at what stage the competentauthority consultation process may be invoked by a taxpayer and whichcompetent authority a taxpayer should go to in order to initiate thatprocess. For example, suppose an adjustment is proposed by State A thatwould increase the income of a parent company in State A and the ad-justment would have a correlative effect on a related entity in State B.May the company go to its competent authority in State A, asserting thatthe adjustment is contrary to the treaty, and ask that the bilateral com-petent authority process commence? (It is assumed, as stated earlier, thatif the bilateral competent authority process is properly invoked, the twocompetent authorities must enter the process of consultation.) As anotherexample, may the related entity in State B invoke its competent authority?

Probably most competent authorities, at least in the early stages oftheir experience, would prefer that the process not be invoked at thepoint of a proposed adjustment and probably not even at the point of aconcluded adjustment. A proposed adjustment may never result in finalaction and even a concluded adjustment may or may not trigger a claimfor a correlative adjustment; even if it does, the latter adjustment mayoccur without problems. As a consequence, many competent authoritiesmay decide that the process should not be invoked until the correlativeadjustment (or other tax consequence in the second country) is involvedat some point.

However, some competent authorities may prefer that the bilateralprocess be invoked earlier, perhaps at the proposed adjustment stage.Such involvement may make the process of consultation easier, in thatthe first country will not have an initial fixed position. In such a case theother competent authority should be prepared to discuss the case at this

106

early stage with the first competent authority. Other competent authori-ties may be willing to let the taxpayer decide, and thus stand readyto have the process invoked at any point starting with the proposedadjustment.

In any event, at a minimum, taxpayers must be informed when theycan invoke the mutual agreement procedure and which competent au-thority is to be addressed (presumably it would be the competent authorityof the country where the invoking taxpayer resides). Taxpayers shouldalso be informed in what form the request should be submitted, althoughit is likely that a simple form would normally be suitable.

D. CORRELATIVE ADJUSTMENTS

Governing rule. It is the general view that a tax treaty should pro-vide that if one country makes an adjustment in the tax liabilities of anentity under the rules governing the allocation of income and expense,thereby increasing the tax liabilities of that entity, and if the effect of thisadjustment, when reflected in the tax status of a related entity in theother country, would require a change in the tax liabilities of the relatedentity, then a correlative adjustment should be made by the second coun-try at the related entity's request if the initial adjustment is in accordwith the treaty standard governing allocation of income and expense.The purpose of such a treaty provision is to avoid economic double taxa-tion. It is clear that the key aspect of a treaty provision requiring a cor-relative adjustment is that the initial adjustment itself must conform to theappropriate arm's length standard. Such conformity thus becomes forthis purpose an important facet of competent authority consultation.

While many countries may be willing to agree that a correlativeadjustment should be made, some countries may believe it appropriateto reserve a degree of discretion to the competent authorities, which couldthen decide that a correlative adjustment need not be made where theyconclude that the actual allocations of the related entities which provokedthe initial adjustment involved fraud, evasion, intent to avoid taxes orgross abuse in the allocation method utilized. Such countries may takethe view that, if a correlative adjustment were required in such situationsand the taxpayer were thus given, in effect, an almost automatic guaranteeagainst the consequence of double taxation, the taxpayer would generallyhave little to lose in initially utilizing clearly improper allocations. Hence,if the competent authorities possess such discretion and there were a riskto the taxpayer of economic double taxation, he would be deterred fromtaking such action and would be more careful in his allocations. Othercountries may feel, however, that the key objective of the treaty shouldbe to avoid double taxation and, hence, matters such as fraud should beleft to other provisions of law, although even here they might concedesome modicum of discretion to be utilized in outrageous cases.

Putting such situations to one side, some countries may not desirea provision requiring correlative adjustments but would leave the entirematter to the discretionary agreement of the competent authorities in theview that the requirement of a correlative adjustment is too strong aninvitation to a country to make a large number of initial adjustments.Other countries, however, may believe that the constraint that competent

107

authorities must agree that the initial adjustment conforms to an arm'slength standard is itself a sufficient safeguard.

It is recognized that, to be effective, a treaty with a correlative ad-justment provision must also provide that any domestic law proceduralor other barriers to the making of the correlative adjustment are to bedisregarded. Thus, such provisions as statutes of limitations and finalityof assessments would have to be overridden to permit the correlative ad-justment to be made. If a particular country cannot, through a treaty,override such aspects of its domestic law, this would have to be indicatedas an exception to the correlative adjustment provision, although it wouldbe hoped that domestic law could be amended to permit the treaty tooperate.

The treaty need not prescribe the method of the correlative adjust-ment since this depends on the nature of the initial adjustment and itseffect on the tax status of the related entity. The method of the correlativeadjustment is thus an aspect of the substantive issue underlying the initialadjustment.

Competent authority procedure. Given this correlative adjustmentrequirement, it is clear that the competent authority process must beavailable at this point. Thus, if the tax authorities of the second countrydo not themselves work out the correlative adjustment, the taxpayersshould be entitled to invoke the competent authority procedure. Hence,as one of the minimum aspects of the competent authority procedure, thecompetent authorities must establish rules as to which competent au-thority the taxpayers may go to, i.e., the competent authority of thecountry in which the related entity seeking the correlative adjustment issituated or the competent authority of the country of the initial adjust-ment, or both. If a time-limit on the invocation is to be imposed, thenthe limit must be stated and the stage at which the time begins to runmust be defined. In some countries when a taxpayer invokes the com-petent authority of its country, that competent authority may be in a po-sition to dispose of the matter without having to consult the competentauthority of the other country. For example, the first competent authoritymay be in a position to handle a matter having potential internationalconsequences that arises from an adjustment proposed by a taxing unitin the country other than the central body. This is, of course, an aspectof domestic law as affected by the treaty.

As another minimum procedural aspect, the competent authoritiesmust indicate the extent to which a taxpayer may be allowed to participatein the competent authority procedure and the manner of his participation.Some countries may wish to favour a reasonable degree of taxpayer parti-cipation. Some countries may wish to allow a taxpayer to present infor-mation and even to appear before them; others may restrict the taxpayer topresentation of data. Presumably, the competent authorities would makeit a condition that a taxpayer invoking the procedure be required to sub-mit to them relevant information needed to decide the matter. In addition,some competent authorities may, where appropriate, require that datafurnished by a taxpayer be prepared as far as possible in accordancewith internationally accepted accounting standards so the data providedwill have some uniformity and objectivity. It is to be noted that rapidprogress is being made in developing international accounting standards

108

and the work of competent authorities should be aided by this develop-ment. As a further aspect concerning the taxpayer's participation, thereshould be a requirement that the taxpayer who invokes the competentauthority procedure should be informed of the response of the competentauthority.

The competent authorities will have to decide how their consulta-tion should proceed once the procedure comes into operation. Presum-ably, the nature of the consultation will depend on the number andcharacter of the cases involved. The competent authorities should keepthe consultation procedure flexible and leave every method of communi-cation open, so that the method appropriate to the matter at hand canbe used.

Various alternatives are available, such as informal consultation bycommunication or in person; meetings between technical personnel orauditors of each country, whose conclusions are to be accepted or rati-fied by the competent authorities; appointment of a joint commission fora complicated case or a series of cases; formal meetings of the competentauthorities in person etc. It does not seem desirable to place a time-limiton when the competent authorities must conclude a matter, since thecomplexities of particular cases may differ. Nevertheless, competent au-thorities should develop working habits that are conducive to prompt dis-position of cases and should endeavour not to allow undue delay.

An important minimum procedural aspect of the competent au-thority procedure is the effect of a taxpayer's invocation of that procedure.Must a taxpayer who invokes that process be bound by the decision ofthe competent authorities in the sense that he gives up rights to alternativeprocedures, such as recourse to domestic administrative or judicial pro-cedures? If the competent authorities want their procedure to be exclusiveand binding, it would be necessary that the treaty provisions be so drawnas to permit this result. Presumably, this may be accomplished underthe general delegation in guideline 25, paragraph 4, by requiring thetaxpayer to waive recourse to those alternative procedures. (However,even with this guideline paragraph, some countries may consider thattheir domestic law requires a more explicit statement to permit the com-petent authority procedure to be binding, especially in view of paragraph1 of guideline 25 referring to remedies under national laws and of thepresent practice under treaties not to make the procedure a binding one.)Some competent authorities may desire that their actions be bindingsince they will not want to go through the effort of reaching agreementsonly to have the taxpayer reject the result if he feels he can do better inthe courts or elsewhere. Other competent authorities may desire to followthe present practice and thus may not want to bind taxpayers or maynot be in a position to do so under domestic law. This would appear tobe a matter on which developing experience would be a useful guide.

A basic issue regarding the competent authority procedure is theextent to which the competent authorities should consider themselvesunder obligation to reach an agreement on a matter that comes beforethem. At a minimum, the treaty requires consultation and the obligationto endeavour to find a solution to economic double taxation. But mustthe consultation end in agreement? Presumably, disagreement would, in

109

general, leave the related entities in a situation where double taxationmay result contrary to the treaty, for example, when a country has op-posed a correlative adjustment on the grounds that the initial adjustmentwas not in conformity with the arm's length standard. On the other hand,an agreement would mean a correlative adjustment made, or a changein the initial adjustment followed then by a correlative adjustment, orperhaps the withdrawal of the initial adjustment. In essence, the generalquestion is whether the competent authority consultation is to be gov-erned by the requirement that there be an "agreement to agree".

It should be observed that, in practice, this question is not as seriousas it may seem. The experience of most competent authorities, at leastas concerns disputes between developed countries, is that in the end anagreement or solution is almost always reached. Of course, the solutionmay often be a compromise, but compromise is an essential aspect ofthe process of consultation and negotiation. Hence, in reality, it wouldnot be much of a further step for competent authorities to decide thattheir procedure should be governed by the standard of "agreement toagree". However, some countries would consider the formal adoption ofsuch standard as a step possessing significant juridical consequences andhence would not be disposed to adopt such a requirement.

It is recognized that, for some countries, the process of agreementmight well be facilitated if competent authorities, when faced with anextremely difficult case or an impasse, could call, either informally orformally, upon outside experts to give an advisory opinion or otherwiseassist in the resolution of the matter. Such experts could be persons cur-rently or previously associated with other tax administrations and pos-sessing the requisite experience in this field. In essence, it would largely bethe personal operation of these experts that would be significant. Thisresort to outside assistance could be useful even where the competentauthorities are not operating under the standard of an "agreement toagree", since the outside assistance, by providing a fresh point of view,may help to resolve an impasse.

E. PUBLICATION OF COMPETENT AUTHORITY PROCEDURESAND DETERMINATIONS

The competent authorities should make public the procedures theyhave adopted with regard to their consultation procedure. The descrip-tion of the procedures should be as complete as is feasible and at theleast should contain the minimum procedural aspects discussed above.

Where the consultation procedure has produced a substantive deter-mination in an important area that can reasonably be viewed as providinga guide to the viewpoints of the competent authorities, the competentauthorities should develop a procedure for publication in their countriesof that determination or decision.

F. PROCEDURES TO IMPLEMENT ADJUSTMENTS

The competent authorities should consider what procedures maybe required to implement the various adjustments involved. For example:

(a) The first country may consider deferring a tax payment under

110

the adjustment or even waiving the payment if, for example, payment orreimbursement of an expense charge by the related entity is prohibitedat the time because of currency or other restrictions imposed by thesecond country;

(b) The first country may consider steps to facilitate carrying outthe adjustment and payment of a reallocated amount. Thus, if income isimputed and taxed to a parent corporation because of service to a re-lated foreign subsidiary, the related subsidiary may be allowed as far asthe parent country is concerned, to establish on its book an account pay-able in favour of the parent, and the parent will not be subject to a secondtax in its country on the establishment or payment of the amount receiv-able. Such payment should not be considered a dividend by the countryof the subsidiary;

(c) The second country may consider steps to facilitate carryingout the adjustment and payment of a reallocated amount. This may, forexample, involve recognition of the payment made as a deductible item,even though prior to the adjustment there was no legal obligation to paysuch amount. This is really an aspect of the correlative adjustment.

G. UNILATERAL PROCEDURES

The above discussion has related almost entirely to bilateral pro-cedures to be agreed upon by the competent authorities to implement themutual agreement procedure. In addition, a competent authority mayconsider it useful to develop certain unilateral rules or procedures involv-ing its relationship to its own taxpayers, so that these relationships maybe better understood. These unilateral rules can cover such matters asthe form to be followed in bringing matters to the attention of the com-petent authority; the permission to taxpayers to bring matters to thecompetent authority at an early stage even where the bilateral proceduredoes not require consultation at that stage; the question whether the com-petent authority will raise new domestic issues (so-called affirmativeissues) between the tax authorities and the taxpayer if he goes to thecompetent authority; and requests for information that will assist thecompetent authority in handling cases.

Unilateral rules regarding the operation of a competent authoritywould not require agreement to them by the other competent authority,since the rules are limited to the domestic relationship with its own tax-payers. However, it would seem appropriate to communicate such uni-lateral rules to the other treaty competent authorities, and to avoidwherever possible material differences, if any, in such rules in relationto the various treaties.

111

II. SUGGESTIONS FOR THE ALLOCATION OFRECEIPTS AND EXPENSES CONCERNINGPAYMENTS FOR GOODS, TECHNOLOGY ANDSERVICES IN RELATION TO TRANSACTIONSBETWEEN RELATED ENTITIES*

Even if a tax administration manages to obtain all the relevant in-formation it needs, it still faces delicate issues regarding the proper allo-cation of cost and income items between the two or more countries inwhich a transnational corporation may operate. Foremost among theseissues are the following: internal pricing (e.g., for parts or materials soldbetween parent and subsidiary); allocation of profits as between contrib-uting activities (manufacturing, assembling, producing, trading etc.) indifferent countries; and allocation of research and headquarters expensesamong all benefiting units in various countries. Improper allocation willdisadvantage one tax authority to the benefit of another or impose doubleor multiple tax liabilities on the taxpayer in respect of the same income.

The Group of Experts therefore devoted considerable attention tothe subject of the tax treatment of transfer prices and the allocation ofinternational receipts and expenses. The Group's discussion indicatedthat members from both developed and developing countries were keenlyinterested in the subject and regarded it as one of the most importantaspects of international taxation.

The Group assumed that a bilateral tax treaty would normally con-tain provisions on business profits (see guideline 7), on associated enter-prises (see guideline 9), on a mutual agreement procedure (see guideline25) and on the possibility of the relevant tax authorities consulting to-gether to resolve difficulties and the willingness of those authorities toco-operate in the resolution of such difficulties for the purposes set forthin the treaty (see guideline 26). The Group further assumed that theaforementioned provisions would embody the following essential prin-ciples in respect of the allocation of receipts and expenses, includingtransfer pricing:

(a) Transactions between related enterprises are to be governedby the arm's length principle. Consequently, if the tax authorities of atreaty country consider that an actual allocation departs from that prin-ciple, they may readjust the taxable profits of the enterprise concerned inaccordance with that principle;

(b) Taxpayers are entitled to invoke the mutual agreement pro-cedure when they consider that such readjustment by one or both of the

* This chapter may require revision at a later stage in the light of the workon transfer pricing currently being carried out by the Committee on Fiscal Affairsof the Organization for Economic Co-operation and Development.

112

competent tax authorities is inconsistent with the arm's length principle;and

(c) The implementation of the mutual agreement procedure isdelegated to the competent authorities of the treaty countries, whichpossess adequate power to ensure full implementation, with the expecta-tion that such implementation will permit the mutual agreement proce-dure to constitute an effective instrument for fulfilling the purposes ofthe treaty.

The following suggestions, which cover many aspects of the taxtreatment of transfer prices and the allocation of receipts and expenses,are not to be construed as a fixed set of rules or as an indication that anelaborate analysis should be undertaken in all cases. Their aim is toprovide the basic framework for an informed approach by tax authoritiesto the problems presented to them in the assessment of the profits oftransnational corporations operating within their jurisdictions by thepractices of those corporations.

A. ALLOCATION OF RECEIPTS AND EXPENSES CONCERNING THE SALEOF GOODS (OR TANGIBLE ASSETS)

1. General considerations

The term "goods" and, possibly even more so, the term "tangibleassets" comprise a very wide variety of items including raw materials(natural produce, minerals etc.) processed natural produce, standardizedsemi-manufactured products, mass-produced manufactures, as well asspecialized items such as antiques and custom-made jewellery or cars,machine tools etc. These suggestions concentrate for the most part onthe main bulk of industrial manufactured products.

As in other transfer pricing situations, the general rule is that, fortax purposes, prices paid between connected enterprises for goods shouldbe those which would be paid by independent parties acting at arm'slength.

It is necessary to consider first the question whether goods might,in the arm's length situation, be supplied for no payment. Except for theprovision of samples or advertising offers, however, this seems so unlikelythat it can perhaps be ignored. There may, of course, be arm's lengthcases where a payment which is due is for some reason not made, butthis does not affect the price. Exchange controls and similar restrictionsshould not be regarded as making exceptions to the arm's length principle.

A second preliminary question to be asked is whether it is possiblethat, in the arm's length situation, goods might be supplied at less thanthe normal market price. There is no doubt that it could happen; forexample, if a company is seeking to break into a new market or breakup an existing one or fend off increasing competition. The possibility can-not therefore be ignored. In a more complex way, too, a company mayfind it necessary to sell some products at a loss in order to make a profiton its products over-all: a clothing company may make a loss on its smalland large garments in order to be able to sell a complete range and makeits profits from the medium sizes; an electric appliance company may selllight bulbs at a loss in order to sell electric fittings, lampshades etc. and

113

make its profit in that way. It would not be unreasonable therefore toaccept the view in principle that there may be some limited circumstancesin which an arm's length price may be somewhat lower than the generalrun of open market prices for that commodity. It would seem, on theother hand, not unreasonable also to suggest that as these circumstanceswould be unusual a claim that they existed and justified a comparativelylow price would have to be examined closely and substantiated by cogentevidence. The prices charged and turnover achieved by the buyer in sell-ing the goods to independent producers could, in this context, providea pointer to the justification for such a claim.

A problem may arise when price controls imposed by the Govern-ment of the country in which the goods are sold limit the profits whichcan be made. The view may be taken, however, that this limits only theprofit of the seller whose price is so controlled.

2. Methods for the allocation pf receipts and expenses concerning thesale of goods or tangible assets

These methods may be divided into (a) methods based on ascertain-ment of the arm's length price; and (b) other methods.(a) Methods based on ascertainment of the arm's length price

These methods comprise the uncontrolled market price method, theunrelated third party price method, the resale price method and the cost-plus method.

Concerning the elements which need to be borne in mind in usingany of these methods, evidence of uncontrolled market prices must ingeneral be given prime consideration since it provides the best guide tothe arm's length price. However, in a situation in which, for example, theuncontrolled market is comparatively limited and the bulk of sales isbetween connected companies in a single group or a few large groups, itmay not be sufficient to rely on such market prices. In the absence ofadequate evidence of uncontrolled market prices, prices paid in sales toindependent third parties seem likely to lead to the arm's length pricemore accurately than other indicators. Indeed, if such sales are truly atarm's length it would be possible to regard the prices paid as, in fact,uncontrolled market prices. Certainly it may be easier for both tax au-thority and taxpayer to look to these prices first. But it is necessary tolook at all the circumstances-sales made by a member of a multinationalgroup to unrelated companies in small quantities might, for example, bemade at unrealistic prices for one reason or another and could well inany case not be properly comparable with bulk sales to affiliated enter-prises which were made on a regular and continuing basis and which, onan arm's length basis, would qualify for sizable discounts.

Either of these two methods seems likely on the face of it to leadmore satisfactorily to the arm's length price than either the resale priceor the cost-plus method, since the first two methods are more closelyrelated to actual market prices than the second two. However, the evi-dence enabling an arm's length price to be arrived at by these two lattermethods may be fuller, less controversial and more easily obtained, inparticular cases, than the evidence of uncontrolled market prices or

114

prices paid by independent third parties, and it is desirable to preservethe possibility of selecting the method which provides the most cogentevidence (subject to checking the results by reference to the others whererelevant). It is not suggested, however, that elaborate calculations shouldbe made by every method in all cases.

The most cogent evidence may often be the simplest. Much will inany case depend on what information is available. It seems likely that,in the case of sales across frontiers, unless the countries concerned haveeffective working arrangements for the exchange of information (and inmany cases even if they have effective arrangements) the assessing taxauthority will have more information about transactions in its own coun-try than in the other; thus, in seeking to assess the arm's length price ofgoods bought by its company from an affiliate in the other country theassessing authority may perhaps find it easier to estimate the appropriateprofit mark-up for the resale of the goods than to calculate the cost andprofit mark-up of the original vendor. Moreover, the resale method hasthe attraction that it begins with a price paid by an independent thirdparty and works back to an appropriate transfer price.

The country in which the original vendor is situated may have moreevidence of comparable costs and profit ratios in its own territory thanin the other and thus find the cost-plus method more attractive than theresale method in arriving at the arm's length price for sales from theoriginal vendor to the reseller. But it ought to be possible for the companyconcerned to adduce evidence from the other country if such evidence isavailable to it. The real problem in all this is the weighing of the evidence.

(i) Comparable uncontrolled market prices and sales to indepen-dent third parties

Comparable uncontrolled market prices may perhaps be more easilyfound in relation to the sale of goods than in relation to many other trans-actions across frontiers. This may particularly be the case with naturalproduce or mass-market manufactured goods, especially if one looks atclosely similar rather than identical products, but there is clearly a widerange of goods where evidence of such uncontrolled sales is lacking.Where the open market is a retail market this will not be directly com-parable and will in any case often display a fairly wide range of priceseven for the same product.

In looking at uncontrolled market prices and prices paid by inde-pendent third parties it is necessary to look at actual prices in preferenceto the offers of competing sellers or the bids of competing buyers, sinceoffers and bids are not always evidence of a firm intention to enter intoa transaction.

The evidence also needs to be reasonably contemporaneous becausemarkets fluctuate and money values change. (This consideration is rele-vant also, of course, to other transfer prices, for example, in the contextof loans, rights or services.)

Considerations to be borne in mind in comparing the prices of thesame or similar goods include the necessity to take account of the factthat prices in one market may vary for one reason or another from those

115

in a different market so that it is necessary to decide what is the appro-priate market. There is an obvious necessity to make appropriate adjust-ments for different costs of transport, packaging, advertising, marketing,servicing, guaranteeing etc. which may or may not be included in thedeal and to take account of minor modifications of the product requiredby the customer's Government or by the exigencies of the relevant market(e.g., car safety features). It must be for consideration whether at someparticular point the differing arrangements involved or the differing modi-fications required render initially similar goods no longer sensibly com-parable for this purpose. Unless there is satisfactory evidence, forexample, of the value of a brand name or trade mark it may not be usefulto look simply to the prices paid in the open market for branded goodsin order to calculate the arm's length price for the same goods in anunbranded package and it may be necessary, therefore, notwithstandingthe fact that open market prices are fully available for branded goods,to resort to the cost-plus method or the resale method or some othermethod of calculating the relevant price in these cases.

Other considerations in this sort of comparison would include differ-ences in quantity-bulk transactions could well be transacted at a dis-count. Evidence on which to base a discount might not be easy to find,although evidence of open market discounts in relation to sales of othergoods might, if treated with care, be helpful.

To what, if any, extent can useful comparisons be made with pricesof quite different goods, if such goods nevertheless perform the same orvery similar functions? The existence of a substitute in the market mightbe expected to result in a convergence of the prices of the original goodsand the substitute. However, consumers, persuaded perhaps by consider-ations of fashion, by clever advertising or simply by prejudice, may preferto remain loyal to the more expensive product or change over from thecheaper one. Such irrational behaviour means that comparisons of thissort are unlikely to be helpful.

(ii) The resale price methodThe resale price method will be easiest to use where the goods are

simply resold by the purchaser. The questions involved there are likelyto be restricted to matters of the reseller's distribution costs and profitmark-up. It will probably be least easy to use this method where thegoods are processed and incorporated in a manufacture before being re-sold. In this latter case there would be the additional problem of identi-fying in the price of the final product those elements of cost and profit(if any) which relate to the particular constituent goods. This may haveto be approached in a fairly broad manner.

The calculation of the appropriate profit mark-up clearly presentsproblems even where the goods are resold in a form which is largely un-changed. The following considerations may, however, be helpful in thiscontext.

The profit mark-up can be expected to be related to the value of thefunction performed by the person reselling the product. This can clearlyrange widely from the case where the reseller effectively performs minimalservices as a forwarding agent to the case where he takes on the full riskof ownership together with the full responsibility for advertising, market-

116

ing and distributing the goods. If the reseller does no more than sell thegoods again, in circumstances where it is clear that he has had to makelittle or no effort, it could be argued that his profit would be a small one.This would particularly be the case for example where he did not takedelivery of the goods-merely receiving and issuing invoices-and hewas operating in a low-tax or no-tax country in which his customers forthe most part did not reside. But even in that situation it could be arguedthat his intervention merited more than a minimal profit if it could beshown that he had some special expertise in marketing or that somespecial convenience was provided to the customer from being able to buythe goods in this way rather than from the original vendor. Such a claimin these circumstances would, however, need to be well supported if itwere to be accepted. It would be more easily acceptable if the resellerwas carrying on a general brokerage business-although this is unlikelyin the context of affiliated companies-in which case, however, the profitmark-up could be related to a brokerage turn. On the other hand, wherethe reseller is clearly carrying on a substantial commercial activity in-volving such operations as the breaking of bulk, packaging, advertising,marketing, transport, distribution and servicing of the goods then a rea-sonably substantial mark-up might be expected.

The profit mark-up may be expected to vary also with regard towhether or not the reseller has the exclusive right to resell the goods.Arrangements of this kind are found in the arm's length situation and theuse of the arm's length concept does not therefore require an exclusiveright of this sort to be ignored. The value of such an exclusive right willdepend to some extent on its geographical scope and the existence andrelative competitiveness of possible substitute goods. The arrangementmay nevertheless be valuable to both vendor and reseller in the arm'slength situation in that it stimulates the reseller to greater efforts to sellthe vendor's particular line of goods as well as providing the reseller witha kind of monopoly. In consequence, the effect of this factor on the re-seller's profit margin, though it may be important in some cases, will needto be examined with care. It may in fact on balance make little difference.

If the reseller sells similar goods which he has bought at arm's lengththis clearly may provide evidence on which to base the appropriate mark-up for the sale of goods bought from an affiliate-although it is necessaryto bear in mind all the considerations relating to the comparability ofgoods mentioned in earlier paragraphs. But in these circumstance s, sincetax authorities are seeking here the taxable profit of the original vendor,they may find it simpler to make direct use of the price paid by the re-seller to the independent party.

(iii) The cost-plus methodThe cost-plus method clearly involves the same sort of problems

relating to the estimation of the appropriate profit mark-up. Costs arealso important in the resale price method-the reselling enterprise mayitself incur costs but the original vendor may incur costs on behalf of thereseller which should be taken into account in arriving at the reseller'sacquisition price. In seeking to arrive at an arm's length price on the basisof cost plus a profit mark-up it is necessary to use only the costs of thevendor. As to how costs may be allocated between vendor and purchaser,

117

some guidance may be derived from the "custom of the trade" where thisis well established. This could be particularly relevant for transport costs,for example, but may also be relevant for others. In other circumstancesit may be necessary to inquire for whose benefit the expense was incurred.For example, advertising expenditure incurred for the sole benefit of thereseller of goods should not be included in the costs forming the basisof the calculation of the arm's length price payable to the original vendor.(In subsection 3 below, advertising expenses are treated in more detailas an illustration of the complexity of the issues that may be involved inthis kind of allocation, although advertising costs are not in practiceusually found to be an important problem.)

Costs in these calculations should include not only the direct cost ofpurchasing materials, semi-finished or finished goods and the costs ofmanufacture or processing etc., but also relevant indirect costs, includingadministrative overheads.

Tax authorities will need to considqr the way in which exceptionallyheavy costs, such as those of a start-up \advertising campaign or the de-preciation of heavy capital equipment, should be attributed to units ofproduction-there is clearly a case in general for spreading these costsover a longer period than one year for the purpose of these calculations.

Another problem here is that of the basis on which indirect costsshould be apportioned-whether by reference to turnover, capital em-ployed, numbers or costs of employees, volume of sales etc. It is clearthat any arbitrary basis can produce unsatisfactory results. If, for ex-ample, world turnover is used, and prices vary from country to country,costs attributed to a country where the price was low could be regardedas unduly low even if the numbers of items sold were the same in eachcountry. It does not appear that any general rules can be devised and theonly practicable solution seems to be to adopt a case-by-case approach.

Where there are sales both to independent third parties and to con-trolled entities, costs which do not relate to controlled sales should notbe allocated to them, but it may not be easy to make the necessary ana-lysis. Where the claim is made that research and development costs orservice costs should be included, care needs to be taken to ensure thatthese costs are not also taken into account elsewhere. Although in thecase of sales of goods by a manufacturing or processing company to amarketing company, such costs may be recovered in the price of thegoods, this is not always the case; sometimes a royalty or service fee maybe charged or a contribution may be levied. Similarly, payment for theuse of a trade-mark may be included in the price charged by the ownerof the trade-mark for the trade-marked goods that he sells, but againthere may be a separate charge. There may also be cases where there isan interest element in the price. In all these cases care needs to be takenthat payment for the right to use the trade-mark, patent or loan is nottaken into account more than once in respect of the same goods.

A related problem may arise in the rather special case in which thegoods comprise patented machinery for use by the purchaser in produc-tion of consumer goods under licence from the seller. Neither the sellernor the purchaser may wish to make a firm price for the machine and itis not uncommon for the machine to be sold at a fixed price (possibly

118

even at cost to the seller), supplemented by payments for the rights toproduce goods with it which depend on the purchaser's output or otheragreed criteria. In principle, the total amount payable or estimated to bepayable (including output-related or other licensing payments) should betaken into account in determining the arm's length price. This could in-volve some form of capitalization of the licensing payments but taxauthorities may well find it appropriate in such a case to treat the output-related or license payments in effect as royalties and to regard the priceof the machine itself as a separate residual item.(b) Other methods

In practice, none of the methods of arriving at the arm's lengthprice so far discussed may be available, because of lack of satisfactoryevidence or for other reasons. In such cases it will be necessary to usewhatever other method seems most likely to achieve a reasonable ap-proximation to the arm's length price.

One alternative is to leave on one side the question "what is thearm's length price?" and try to answer instead the question "what is thearm's length profit?" by apportioning to the relevant connected companysome part of the group's total profit by reference to the relative economicvalue of the function which it undertakes. It is in order to ascertain thearm's length profit, in fact, that it is necessary to ascertain the arm'slength price and to go directly to the profit would have some attraction ifthis were more simply arrived at than the arm's length price. But this ap-proach involves many difficulties. Related companies rarely operate overthe same product range in a fully comparable way and the attribution ofa value to particular functions (such as research and development, manu-facturing, final processing and marketing) raises many controversialissues.

Another approach may be to examine the return on capital em-ployed. This involves difficulties of definition-what in fact is the capitalemployed? It also involves difficult comparisons-some industries arecapital-intensive, others are labour-intensive. This, too, therefore is amethod which needs to be used with great caution.

Finally, in the interests of equity and ease of administration and forthe benefit of both taxpayers and tax authorities, tax administrationsshould lean as far as possible, in this sort of exercise, in the direction ofsimplicity as opposed to complexity. They should look, in short, for themost straightforward method available in the circumstances in so far asthis does not obviously lead to injustice to the particular company onone hand or the general body of taxpayers on the other. (Clearly, how-ever, a tax authority cannot be prevented from making whatever reason-able detailed inquiries it considers to be necessary.) Similarly, transferprices actually adopted should not lightly be upset and if a controlledtransfer price could reasonably be an arm's length price it should be ac-cepted notwithstanding the fact that some other figure could reasonablybe substituted for it. Furthermore, changes should not be made if theamounts involved are small, unless an important point of principle is atstake.

3. Special problems concerning the allocation of advertising expensesIt is in the interest of manufacturers of branded goods, whether or

119

not the distributing trade is already prepared or even wishes to buy theirproducts, to open and maintain outlets for their products by advertising,and they would normally include any advertising expenses which theyhave effectively borne in the price charged for their goods. Ordinarilythe reseller would not assume on his own account the responsibility for ad-vertising the brand as opposed to advertising his own business (thoughthis might include advertising the fact that particular branded goodscould be bought from him). A sole distributor might, however, take onsuch responsibility either in whole or in part. It does not follow that heinvariably would, but, if he did, then the price he paid to his supplier forthe goods should be accordingly lower than if he did not. The necessityin such cases is to determine the facts.

On the other hand, when a transnational group advertises thebranded goods which it manufactures and markets, the benefits of thisadvertising are not confined to the marketing outlets, but are spreadthroughout the group, since any increased sales resulting from the ad-vertising increase the turnover of the manufacturing entities and arelikely, in consequence, to increase their arm's length profits. No matterhow the expenditure is actually borne, whether by the head office, by thecompany engaged at the final stage, or by some or all of the companiesinvolved in the entire process, if it is important to take this into account,a quantification of benefit accruing to each company has to be attempted.Ideally each item would need to be costed and examined in an effort todetermine in whose interest it is incurred.

The expenses of finding, establishing and maintaining a market coverthe whole range of advertising activities. These activities appear to fallinto three broad categories:

(a) General advertising (e.g., through the mass communicationmedia and by display posters);

(b) Specific advertising to actual or potential customers (e.g.,through trade journals); and

(c) Advertising through exhibitions and demonstrations.However, although this break-down may help in identifying the type ofadvertising expenditure incurred, it will not automatically determine theallocation, for example, between manufacturer and retailer or betweencompanies engaged at different points of the production cycle.

It might be helpful to consider the respective functions of the com-panies in the group. For example, if it was the parent company's functionto pay for the advertising expenditure of the whole group, it would seemclear that the parent should charge some of the cost of such advertisingto the subsidiaries. The particular method of charging might not, however,be easy to compute. If, on the other hand, the group's business consistedmainly of sales in a number of different countries of products tailored tothe peculiarities of the markets in those particular countries, then thepractice might be to require a subsidiary in each country to bear thecost of local advertising; in that event, the cost and benefit could fairlyreasonably be isolated to each subsidiary, although it might still be neces-sary to consider expenditure accounted for by general world-wide ad-vertising if borne centrally.

The apportionment of costs and benefits is the nub of the matter.On the assumption that advertising increases the turnover and profits of

120

all the members of the transnational group, each one ought to bear anappropriate share of the expenditure. But on what basis should that sharebe calculated? One method might be to relate it to turnover, but that wouldbe unlikely to be wholly appropriate because it is most improbable thateach company's profitability will be the same. An alternative might be torelate it to capital employed, but again the required rate of return oncapital is unlikely to be the same throughout the group. Another possi-bility might be to pay regard to profit levels on the assumption that profitis directly related to expenditure on advertising. This, however, is toobroad an assumption. In addition, the prerequisite here is that any ap-propriate transfer pricing adjustments to profit levels throughout thegroup have to be decided by reference to an amalgam of these three, andpossibly other, methods.

Although there seem to be comparatively few general principleswhich can be put forward, the following indications may be helpful:

(a) The cost of widespread advertising undertaken by a manu-facturer direct to the general public in order to attract the attention ofcustomers to the brand would normally be expected to be borne by com-panies engaged in the manufacturing process;

(b) The cost of local advertising by a distributor, directed specifi-cally towards markets within his own area and designed to increase hisown busigess, pould generally be allocated solely to him.

There seems no doubt that, unless it were properly allocated byreference to benefit, the cost of advertising could be used as a method ofshifting profits inappropriately to the fiscal advantage of a transnationalgroup. The problem of the proper allocation of advertising expendituremay, however, be extremely complex and even very detailed investigationwould not necessarily achieve a very precise result in most cases.

It will often be necessary therefore to approach the matter on abroad basis in the light of the circumstances of each case.

B. ALLOCATION OF RECEIPTS FROM THE USE OF PATENT RIGHTS

1. General considerations

Research and development costs may be allocated to the differententities of a transnational group of companies in various ways and theseentities may similarly benefit from and pay for the fruits of such activitiesin various ways. In the following paragraphs an attempt is made to pro-vide guidelines for tax authorities in dealing with the main categories ofsuch receipts and expenditures.

In practice, payments for the products of research and development(R and D) may often be included in undifferentiated payments under ar-rangements which may be loosely described as "package deals" incor-porating the right to use not only patents and know-how but also trademarks, as well as the right to receive various related technical, adminis-trative and other services. They may also be included in the price ofgoods. Separate consideration is given here, however, to payments for thetransfer of technology, payments for services and payments for goods inorder to simplify the analysis of the problem and to outline the principlesinvolved in dealing with such payments, so that they can be treated con-sistently whether or not they are comprised in package deals. But the

121

separate treatment given to these kinds of payments for the purposes ofanalysis should not be allowed to obscure their interconnexion.

An important consideration to be borne in mind is that at each stagein the R and D process, the final commercial benefits to be derived remainuncertain, although no doubt more so at the research than at the develop-ment level, and the degree of risk involved makes it difficult to estimatebenefits from the outlays made which, in the event that some R and Dprojects prove successful commercially, will only materialize in the future.Moreover, companies will understandably seek to recoup the cost offinancing unsuccessful research from the results of successful research.

Expenditures on R and D (including the cost of unsuccessful proj-ects) are likely to be recovered in two main ways. Some expenditureswill be recovered from the sales of the goods which are facilitated by theresults of successful R and D expenditure and some will be recovered inone way or another from the sale and licensing of the intangible propertycreated by the successful R and D activity. In both cases, taxable profitswill accrue to the firms using the results of the R and D against which thecosts involved can be offset.

R and D activities within transnational groups of companies may beorganized and financed in a variety of ways. Companies may undertakeand use the results of their own research and development. In some trans-national enterprises R and D is undertaken by one or moreThembers ofthe group, the results being made available to the other members of thegroup, mainly by way of licensing contracts. In such cases, R and D ex-penditures will not be recouped until such time as any intangible propertyis developed. Other transnationals find it convenient, however, to arrangefor R and D to be done centrally and to be paid for by varying forms ofcost contribution arrangements which spread the R and D expenses (andoften other expenses, such as the cost of services and overheads) amongthe different companies participating in the agreement; in such a way,R and D expenditures may be recouped before any item of intangibleproperty is developed. It may occur also that R and D are undertaken byone member of a group at the specific request of another.

The pricing policies operated in relation to intra-group transfers ofintangible property by related companies in transnational groups presenta number of difficulties for national tax authorities, since the terms andconditions of such transfers may not correspond to the economic realitiesbut may be used-partly because of the differences of national tax sys-tems-as a means of shifting profits between members of the group inorder to alleviate the over-all tax burden of the group.

Tax considerations may themselves determine the way in whichR and D expenditures are recovered as well as the form and amount of atransfer price or of a cost allocation. This may be the case particularly,for example, where the tax laws of a particular country treat one kindof payment differently from another by allowing or refusing a deductionor by requiring, or not requiring, certain kinds of payment to be madeunder deduction of withholding tax. It can happen also where one of therelated entities operates in a country with a lower tax rate than that inwhich the other operates, or in a country with no tax at all. These factorsmay be expected to influence the nature of the payment, since it is likely

122

that some transnational enterprises may be more concerned with thetotal of their net earnings after tax through royalties, cost charges, servicefees, profits from intercompany sales and dividends paid by their affiliatesthan with the form which these earnings take. On the other hand, it hasto be recognized that, in many instances, tax considerations are unlikelyto be paramount where, for example, firms are subject to conflictingpressures from various government departments-in the home as wellas in the host countries-including customs authorities, exchange or pricecontrol offices and others, or where the different entities of a group facethe scrutiny of minority shareholders and of auditors. Moreover, localmanagers wanting to show a good profit record for their subsidiaries mayresist fixing excessive transfer prices for rights if profits would therebybe reduced.

The fact remains, however, that the respective tax authorities haveto consider if, and to what extent, such payments should be adjusted fortax purposes.

A transfer of intangible property can be made in various ways. Insome instances, there is a transfer of the property itself by way of succes-sion (e.g., mergers) or by way of a sale, exchange or donation contract.More frequently, while the property itself remains in the same hands, theright to use it will be transferred by way of licensing agreements or inresponse to cost contribution arrangements; these suggestions deal withthese two latter forms of transfer only, so that only the use, and not thesale, of patents and know-how is discussed at this stage. This is for con-venience of the analysis, though there may be cases where it is difficultto determine, whether the developer sells a right or merely makes it avail-able to another person for a limited period of time. The suggestions dealfirst with payments by way of licensing agreements and similar arrange-ments and secondly with cost contribution arrangements.

2. Definitions

(a) Intangible propertyThe term "intangible property" includes industrial property rights

such as patents, trademarks, designs or models, plans, secret formulaeor processes, know-how or other information concerning industrial, com-mercial or scientific experiences.

(b) Patents and know-howA patent gives a legally protected monopoly right to an invention.

The term know-how is perhaps a less precise concept. The commentaryon article 12 of the 1977 OECD Model Convention on Double Taxationof Income and Capital (para. 12) gives the following definition: "Know-how is all the undivulged technical information, whether capable of beingpatented or not, that is necessary for the industrial reproduction of aproduct or process, directly and under the same conditions: inasmuch asit is derived from experience, know-how represents what a manufacturercannot know from mere examination of the product and mere knowledgeof the progress of technique." Know-how thus may include secret pro-cesses or formulae or other secret information concerning industrial,commercial or scientific experience which is not covered by patent.

123

It may be important for tax purposes to distinguish clearly betweena transfer making available the use of know-how to another party, andtechnical assistance or similar activities which constitute personal ser-vices. Again the commentary on article 12 gives some indications whichmay be helpful in this respect: "In the know-how contract, one of theparties agrees to impart to the other, so that he can use them for his ownaccount, his special knowledge and experience which remain unrevealedto the public. It is recognized that the grantor is not required to play anypart himself in the application of the formulae granted to the licenseeand that he does not guarantee the result thereof. This type of contractthus differs from contracts for the provision of services, in which one ofthe parties undertakes to use the customary skills of his callidg to executework himself for the other party." Examples of personal services wouldbe pure technical assistance, an opinion given by an engineer, a lawyeror an accountant and services in connexion with the sale of goods, suchas after-sales services or services rendered by a seller to the purchaserunder a guarantee. However, in practice, it may often be very difficult todetermine where the exact borderline runs, since know-how contractsoften include a service element.

3. Payments for patents and know-how developed by one company forother companies in the same group

Intra-group contracts, which license patents or know-how, are fre-quently concluded between a parent company as the developer which hasborne the entire costs of the development, and one or several of its sub-sidiaries. Where groups h-ve formed research units in different countries,subsidiaries may also license the intangible property they have developedto the parent or to the other subsidiaries. Reciprocal licensing (cross li-censing) is not uncommon and there may be other, more complicated,arrangements as well.

A prerequisite for allowing payments under licensMk 'agreementsas a deduction for tax purposes is that a real benefit should have accruedor be capable of accruing to the licensee. It would normally be expectedthat a licensing agreement should be concluded in writing, defining asclosely as possible the nature of the intangible property which is involved,and hence providing a basis for assessing the benefit conferred. In addi-tion, the taxpayer could properly be required to produce all the evidenceneeded by the tax authorities to check if a benefit has in fact been con-ferred on him as licensee in the particular case. It is clearly important todetermine what is the underlying reality behind an arrangement, irre-spective of the latter's formal aspect.

Although it has to be demonstrated that the patent, or know-how, inquestion is in fact useful for the particular needs of the company payingfor it and that a real benefit is thereby conferred, this point should notbe confused with the separate matter of the calculation of what is theappropriate rate of payment to be made for that benefit.

The general principle to be taken as the basis for the evaluation fortax purposes of transfer prices between related companies under contractsfor licensing patents or know-how is that the prices should be those whichwould be paid between independent companies acting t.gjm's length.

124

Such transactions should not be treated differently for tax purposes fromsimilar transactions between independent parties solely by virtue of thefact that the companies are affiliated. Thus, if payments for the use ofintangible property are deductible for tax purposes when made betweenunrelated companies, similar payments made in similar circumstancesbetween related companies in a group should be treated similarly. Also,in conformity with article 24 of the OECD Model Convention, a deduc-tion should not be refused on the grounds that the payment is made to anon-resident.

Problems may arise in cases in which an affiliated company has beenexperiencing financial difficulties and in which exchange controls or simi-lar restrictions have prevented the effective transfer of a payment, and taxauthorities may have to decide in each case whether to treat a paymentas waived. It seems hardly likely, however, that in an arm's length situa-tion a licensor would waive or defer payment of royalties because of thefinancial difficulties of the licensee. The licensor would usually be en-titled to withdraw the right to use the intangible property. Exchange con-trols and similar restrictions should not be regarded as creating exceptionsto the arm's length principle.

It is reasonable to look for a form which is compatible with the formwhich would be adopted in transactions between unrelated parties underthe same circumstances, but it has to be taken into account that there area number of forms which might be adopted in an arm's length situation.Usually, a royalty or a know-how fee would be paid, that is, a recurrentpayment based on the user's output, sales or, in some circumstances,profits or some other measure. When such royalty payments are basedon the licensee's output or sales the percentage may be degressive if thiswould be usual between independent parties. The consideration may alsotake the form of a lump-sum payment, sometimes combined with a re-current payment. Companies may also agree on reciprocal licensingrights. The compensation for the use of intangible property may be in-cluded in the price charged for the sale of goods when, for example, onecompany sells unfinished products to another and, at the same time,makes available its experience for further processing of these products. Insuch circumstances any additional payments for royalties would ordinarilybe disallowed by the country of the buying company, but much woulddepend upon the facts of each deal and the real value of the goods andrights transferred. There would appear to be no general principle whichcan be applied except that the payment or receipt for the provision ofthe technology should not be included in (or, if appropriate, deductedfrom) the relevant receipts more than once.

The arm's length consideration may sometimes be determined bylooking to licence contracts that the same developer has concluded withunrelated parties involving the same or similar intangible property underthe same or similar market conditions. Likewise, the offers to unrelatedparties, or the genuine bids of competing licensees, could be consideredwhen the data exist. Where the user sub-licenses the property to thirdparties, the price paid by the latter may be relevant. The amount of con-sideration for similar transactions between unrelated companies in thesame industry may also be a guide. In many cases, however, it will be

125

difficult to find satisfactory comparable open market transactions, sincethe owner of intangible property (and particularly the owner of a patent)is essentially the owner of a monopoly right.

In using evidence provided by comparable transactions in seeking toarrive at the price to be taken for tax purposes in relation to an intra-group licence contract, it is necessary to take all the circumstances intoaccount. This is as much the case where the evidence is provided bytransactions between completely unrelated parties as in other circum-stances. It is not suggested that an elaborate analysis will need to be madein all cases but in any one case it may be necessary to take account ofseveral of the following factors.

The expected profits and conditions in the relevant market canclearly affect the amount, and account needs to be taken of the possibilitythat the fee paid in one market may not reflect the arm's length price inanother.

The terms on which the transfer of the intangible property is madeneed to be considered; limitations on the geographical area in which rightsmay be exercised, export restrictions on goods produced by virtue of anyrights transferred, and the exclusive or non-exclusive character of anyrights granted may affect the amounts payable (the amount of the con-sideration to be paid by the licensee may be expected to be higher, forexample, if an exclusive right is conferred than if there are restrictionsor limitations on its use).

The value of services, such as technical assistance, training of em-ployees and so on, rendered by the developer in connexion with the trans-fer may have to be allowed for. The payment for the combined packagecould be expected to be larger than the payment for the transfer of rightsalone.

The nature of a patent can also be important; it is likely that anentirely new "break-through" patent which has a special distinctivenesswill command a higher price than one either designed to improve a pro-cess already governed by an existing patent or one for which substitutesmay be readily available (although the expectation of a greater returnfollowing a greater volume of sales of the goods produced may also affectthe price, and a break-through patent may also, because of its novelty,be hard to evaluate).

The length of the period during which patents and know-how etc.are likely to maintain their value will also affect the amount of the pay-ments which would be required for the right to use them; this periodmay vary widely, since in some branches of industry techniques are su-perseded more quickly than in others.

The degree and duration of protection afforded under the patentlaws of the relevant countries is variable, but this factor must be evalu-ated, bearing in .mind that new patents may speedily be developed on thethe basis of old ones, so that the effective protection of the intangibleproperty is prolonged correspondingly.

The process of production for which the property is used and thevalue it contributes to the final product have to be taken into accountand it would not necessarily be appropriate, for example, if the royalty

126

on a patented invention which only covered one component of a devicewas calculated by reference to the selling price of the complete product.In a case where an invention covers only one part of a complicated ma-chine, a royalty of a small proportion of the selling price of that machinemay seem reasonable at first sight but may well be exorbitant if this com-ponent is measured by reference to the value of other components andif its impact on the final product is compared to the impact of other parts.

If the licensee has the right to participate in further developmentsby the licensor or if, on the contrary, the licensee is under the obligationto impart further improvements of an invention, or other intangible prop-erty, to the licensor, these circumstances will influence the level of thepayment made for the original patent or know-how. In arm's lengthsituations cases arise where the payment made to the licensor varies ac-cording to the turnover of the licensee, frequently being at a lower rateif sales exceed a certain figure. Variations in rates may be justified alsoaccording to the extent to which the intangible property concerned hasalready been used by the licensee in production.

Where a sufficiently similar transaction involving an unrelated partycannot be found, or does not provide satisfactory evidence, other methodshave to be used as a means of testing whether the price actually paid bythe licensee is acceptable to the tax authorities. Usually it will be neces-sary to take account of more than one method in reaching a satisfactoryapproximation to arm's length price.

An approach often employed in practice is to make a pragmaticappraisal of the trend of an enterprise's profits over a long period incomparison with those of other unrelated parties engaged in the sameor similar activities and operating in the same area. There could, ofcourse, be many reasons for an unusual profit situation and it may bepossible for the taxpayers to give satisfactory explanations for particularcases. The profit comparison approach thus remains no more than anindication that the consideration charged for the use of intangible prop-erty may or may not be reasonable.

The recourse to a comparison of the proportionate profits of thelicensor and the licensee achieved thanks to the development and the useof the intangible property is a possible but not very promising method. Itwould be difficult to isolate the respective profits of the licensor and thelicensee, since a number of rights may be under licence at the same timefor the manufacturing of different products and the accounting methodsin the countries concerned may differ fundamentally. In addition, thereis the basic difficulty of knowing how to apportion the over-all profit be-tween the licensor and the licensee.

It may be useful to look at the costs incurred by the licensor in de-veloping the property. However, the actual arm's length open marketprice of intangible property is not related in a consistent manner to thecosts involved in developing it. If the research results in a successful (i.e.,profitable) product the price will exceed the cost, possibly by a very largemargin. Ltss successful products may recover less than their cost of theunderlying research. Moreover, costs for successful research may oftenhave to include the cost of unsuccessful research if any research activityis to be carried on at all. The uncertainties attendant on-the eventual re-

127

turn on expenditure on R and D and the length of time during which apatent will prove to be commercially usable together with the monopolyelement present in patent licensing therefore make reference to cost haz-ardous. Moreover, it may not be easy to determine what the costs con-nected with the development of a particular item of intangible propertywere when research is performed in a group on a large scale and for vari-ous purposes. Despite these difficulties, there may be cases where thecost-oriented method gives some guidance, at least as regards the lowerlimit for the licensor's profit in normal circumstances. Looking at thecosts may also be appropriate to verify a provisionally acceptable priceafter other methods have been applied.

It may be thought possible to provide some pragmatic guidance bybuilding up from information available to the tax authority in its filessome sort of standard range of rates for royalties and similar payments.However, it is in practice very difficult to discover any satisfactory rela-tionship between the rates or ranges of rates payable even within a givensector of industry, since the profits and their relationship to the productsof the users vary so widely, and this method does not, in fact, seem to bea very promising one for tax authorities to adopt.

4. Cost contribution arrangements among related companiesfor R and D expenditure

Some transnationals use cost contribution arrangements to financeR and D expenditure as or before it is incurred instead of selling or li-censing patents or know-how after they have been successfully developed.This method of recouping R and D costs is not very common but it hasbeen used over recent years by several large transnational enterpriseswith extensive and costly research activities undertaken on a world-widebasis. Some of these arrangements also cover the costs of various services(mainly costs of technical assistance but often including also the cost ofmanagement and administrative services).

Although not numerous, cost contribution arrangements in practicetake a variety of forms. They may be considered, however, as falling intotwo main categories. There is, first, the cost-sharing arrangement underwhich members of the group agree to share the actual costs and the risksof R and D undertaken for the benefit or expected benefit of each ofthem. In such cases, each participant would bear its fair share of the costsand risks and would in return be entitled to its fair share of any usableresults of the R and D. The arrangements resemble in some respects ajoint venture or partnership. Secondly, there is what may be described asthe cost-funding arrangement (which would be very unusual among un-related companies) under which members of the group contribute in amore general way to the cost of the R and D programme of the group.Usually this contribution would take the form of a generalized fee andwould not be related to the actual cost of any specific R and D activity.Such arrangements may be likened to a mandate given by the members ofa group to the company which is responsible for the R and D programme(which may often be, but will not always be, the parent company) toengage in or procure R and D for the benefit of the group. In such cases,the actual results of the R and D may well be owned by a single com-

128

pany-frequently the parent company-which will have the primaryresponsibility for the patent, although the results, if any, of the R and Dwould usually be made available to all the contributing members of thegroup.

Countries will have to decide how far payments of this sort can beaccepted for tax purposes either as approximating to other paymentswhich would be made between companies acting at arm's length or aspayments which would in fact be made in an arm's length situation. It isnot possible to dismiss completely the likelihood that cost contributionarrangements are to be found in the arm's length situation.

Some countries have special rules for cost-sharing arrangements.Under certain conditions companies taking part in such arrangements areallowed for tax purposes to charge or to deduct as expenses the actualcosts involved without the addition of a profit mark-up. The explanationof this is that various forms of cost-sharing arrangements exist in practicein those countries and, in so far as the arrangements are consistent withthe arm's length principle, a need is felt to accommodate their existencein the regulations.

Both cost-sharing and cost-funding arrangements present tax au-thorities with numerous difficulties and for tax purposes adjustmentsmay often have to be made to the payments passing between the parties.However, in reaching a decision on this point, much would depend uponthe precise conditions of such an arrangement in a transnational groupand the justification provided in terms of benefits received and costsincurred.

The terms and conditions of cost contribution arrangements must beexamined in each particular case to determine whether the research isactually performed in the interest and for the real benefit of the respec-tive parties; in this sense a potential benefit would be a real benefit(although only if the relevant party has a genuine and substantial interestin the results which the research may produce). Thus, inter alia, the re-search carried out would have to be closely related to the specific needsof the participants. The terms and conditions of an arrangement must becomparable to those which would have been adopted by unrelated partiesunder similar circumstances. Cost contribution arrangements betweenindependent parties are uncommon except for special projects, so that itwould have to be established that the respective participants are really ina position to benefit from the various research projects. Normally, onlymanufacturing companies would be expected to be found as participantsin a cost contribution arrangement, since trading companies would expectto recover their cost in the price of the goods sold, but there may be ex-ceptions. The contributions by participants must be made for researchprojects in which they are in fact interested and should not lead to anexcessive build-up of funds in the hands of the research company.

It would normally be reasonable to expect that the terms of a costcontribution arrangement would be laid down in a written contract con-cluded in advance and be precisely defined, although this is not necessarilyalways the case. In addition, the participants in the cost contribution ar-rangement could be expected to be able to demonstrate that the R and Dthey are paying for is in conformity with the written agreement and has

129

been or will be carried out in practice. It would be for the company toproduce, at the request of the tax authorities concerned, all the evidenceneeded to prove that the research haq been carried out in its interests andin anticipatidn of real benefits. Here again, it is more important to lookat the substance than the form of an agreement.

Although it cannot be expected that all, or even most, research proj-ects will be successful, if a subsidiary participating in a cost contributionarrangement has not benefited from substantial developments over a longperiod of time, this may be an indication, since the R and D budgets ofindependent enterprises are naturally profit-oriented, that the researchwas not carried out in the interest, and for the benefit, of that particularcompany. An independent firm would not be likely to participate in suchan arrangement if it received no benefit over a long period.

A contribution of this sort could reasonably be expected to be de-signed to recover not only the direct costs but also some, at least, of theindirect costs of R and D. Indirect costs are those which are not specifi-cally identified with a particular research or development activity butwhich relate to the direct costs. They would thus include costs with respectto supervisory, clerical, administrative and other overhead activities inaccordance with generally accepted accountancy practice. It could, how-ever, be difficult in practice to determine such costs precisely.

Costs of a capital nature, such as expenditure for buildings, ma-chines and other assets necessary for the research, might be allocated onthe basis of the allowances for depreciation of property. Recognition mayhave to be given to special allowances for R and D capital costs. Prob-lems may arise from the fact that tax laws and depreciation practices varyfrom one country to another and tax authorities may have to considerhow, by consultation between each other under the double taxation agree-ments, they can resolve such disputes.

In a genuine cost-sharing arrangement, only net costs would be sub-ject to allocation, the costs of research at request being charged directlyto the requesting party and any licence receipts or receipts from the saleof research assets being deducted from the amount to be allocated amongparticipants. Any subsidies granted to the developer by a Governmentwould also be deducted. Any excess of receipts over gross costs in anyyear would normally be distributed, or credited, to the participants inthe arrangement. In a cost-funding arrangement, the answer to the ques-tion whether, and to what extent, the remuneration received by the re-search company from third parties or government subsidies ought to beconsidered as reducing the contribution, may depend upon the formulaadopted for the calculation of contributions by the group-whether, forexample, the contribution is or is not closely related to the use which thecontributor is expected to make of the results of the research and develop-ment. It would not be essential to take account of marginal remunerationfrom third parties. As in the case of licence and royalty arrangements, itwould be important for tax authorities to watch closely that costs ofR and D are not double counted by being included in the price of goodsthat have been sold to one of the participants of the arrangement.

It is possible to have differing views on the question whether thecontributions of the participants in a cost contribution arrangement shouldinclude a profit element; it seems right, however, that in cases where

130

R and D are carried out to order, the firm carrying out the research ordevelopment activity should be expected to carry it out for the profit andthus should be required to charge, in addition to costs, a profit mark-up.It would follow that the profit mark-up would then form part of the ex-penses incurred by the contributing companies. To the extent that thecompany carrying out the research is relieved of risk because it couldrely on its costs being met by the participating companies, then, again, itseems right that any profit mark-up should not take account of such risksand ought to be limited to a reward for its activities in organizing andmanaging the relevant research project or projects.

Separately incorporated research companies supported by contribu-tions from affiliated firms would carry out research in the interest ofother members of a group and would not use the results of the R and Dfor their own purposes. Such research companies should ordinarily berequired and allowed therefore to charge costs plus a profit mark-up toreflect their efforts in organizing and managing the research effort.

The costs of R and D have to be allocated in a fair and equitableway to the participants of a cost contribution arrangement. There is noformula that could be universally applied as the circumstances may varyconsiderably. Some groups allocate costs in proportion to the expectedbenefits of the parties involved and this seems a reasonable approach.Others allocate costs according to the proportionate turnover of the par-ticipants. This rule of thumb may provide a reasonable measure of even-tual benefits conferred, but it may also lead to distortions and this typeof allocation formula would have to be scrutinized closely by the tax au-thorities in the countries concerned.

The tax treatment of any contributions to R and D carried out byanother company abroad varies from country to country. The paymentscould be deductible as an expense or be charged to capital account ortreated in either way according to the choice of accounting procedures,where a choice is permitted. Special rules may apply when the companymakes payments to a separately incorporated research company which ithas established together with other firms. This may mean that what istreated as a revenue payment in one country may have to be treated as acapital payment in the other and vice versa.

A withholding tax, which in some countries applies to royalties, isunlikely to be levied by such tax authorities when the parties have con-cluded a cost contribution arrangement. In the context of the problemof profit mark-up on cost contributions, the question may be raisedwhether, when such contributions include a profit element as in certaincircumstances a royalty may do, they should not also be subject to awithholding tax. It seems clear, however, that these payments are simplyingredients in a calculation of business profits and differ in character fromroyalties and ought not to be treated in the same way with respect totaxation at source.

C. ALLOCATION OF RECEIPTS FROM THE PROVISION OF SERVICES

1. General considerations

Owing to the frequently high degree of integration and interdepen-dence within transnational groups, a large amount of expenditure is

131

usually required to co-ordinate their activities and to achieve commongoals. Transnational enterprises therefore face the problem of whetherand how costs for services should be paid by the different members ofthe group. The practice of transnational enterprises in charging for ser-vices and various central staff activities differs widely. On the other hand,tax authorities are also much concerned with these problems. The follow-ing suggestions are designed to assist them in their task.

The problems are linked with those faced in dealing with paymentsfor the transfer of technology. Indeed, it is often very difficult to deter-mine where the exact borderline is in some cases (e.g. know-how con-tracts). Also, it is the practice of some transnational enterprises to have aglobal approach to the provision of services and to the allocation of therelevant costs within the group, covering both research and development,technical assistance and other services. Some of the considerations alreadydiscussed in section B above would therefore be relevant here, whetheridentified types of services are rendered by one member of the group toanother, or cost contribution agreements are employed. Again a separatetreatment for the purposes of analysis should not be allowed to obscurethese interconnexions.

Though some services may be provided within a transnational en-terprise which are of the same nature as those provided by independentcompanies, others are specific to transnational enterprises and arise fromthe fact that transnational groups constitute an economic unit in whichall entities are subject, to some extent, to an over-all plan drawn up inthe interests of the strategy of the group as a whole which is controlledby the parent company. For this purpose, the group has to maintain staffand equipment, at headquarters or otherwise, for the supervision of, andprovision of assistance to, other members of the group. When assessingthe taxable profits of the latter, the tax authorities of the countries con-cerned will have to decide, in accordance with the arm's length principle,whether by nature the services rendered were of a kind to justify somepayment or contribution by the company under consideration and whethera real benefit was conferred or was partially conferred.

The provision of services within a group can be organized in variousways, and this may create difficulties when tax authorities are trying todetermine in whose interest specific services are being performed. Spe-cific services would generally be rendered by a parent company but itcan also happen that a subsidiary renders services to its parent or toother affiliated companies, or that services are performed reciprocally.Some groups have established separately incorporated service companies(which could take the form of joint stock companies or of partnershipsor possibly other forms).

2. Nature of the services

A first category of services performed in a transnational group,comprises services undertaken by the parent company in its capacity asshareholder. This clearly includes audit activities performed by the parentcompany to inform itself about the financial situation of a subsidiary andthe relevant reporting processes, the preparation of shareholders' meet-ings and the selection and appointment of directors of subsidiaries. Similar

132

costs may be incurred by the parent company, or an intermediate holdingcompany, for the co-ordination or control of the various interests notamounting to a controlling participation in other companies.

A second important category covers the range of services which aparent company may perform in its role as the co-ordinator, supervisorand initiator of the group's activities. Here, too, the parent company'sinterest as shareholder is at stake to a certain degree. Such services wouldinclude the basic organization of the group (e.g., the arrangement ofcapital increases or loans for subsidiaries, the creation of new companies,the acquisition and disposal of old companies, mergers etc.). They wouldalso include centralized planning in fields such as finance, investment,production, marketing, joint advertising or market research, consolidatedaccounting and centralized public relations. These "management" ser-vices may be seen as benefiting the group as a whole; but it may be ar-guable that to some extent a number of them are of direct benefit toparticular subsidiaries. The expenditure involved, however, may well becapital rather than revenue in some cases.

A third category of services whose organization may either be con-centrated at the parent-company level or delegated to specialized com-panies in the group, consists of the provision of services "on call" whichcould be rendered on an arm's length basis between independent firms.This covers activities such as the provision of financial resources of com-mercial, organizational or technical experience, or of computer services,as well as legal, accountancy or tax services. Companies in a group mayalso provide services for each other in other ways-lending or hiringeach other's staff, equipment etc.

3. The allocation of costs within the transnational group

Specific services directly rendered by one member of the group toanother therefore represent only a limited part of the whole "provisionof services" in a group. The costs of management, or "central" services,which are in the first instance often borne by the parent company (or aspecialized company) may represent substantial amounts, which the com-pany would need to recoup from other companies. Indeed, companiesmay be tempted to recover cash flows from abroad through such sharingof costs rather than through obtaining dividends from the subsidiary. Itis therefore necessary to look carefully at the cost allocation systemadopted.

Corporate practice in allocating central expenditures differs widelyaccording to circumstances. Sometimes, even within a group, no uniformsystem is applied. Tax regulations or the attitude of the tax authoritiesmay also affect the practice.

Some transnational enterprises consider that overhead costs areincurred primarily to benefit the parent company and that they shouldnot be attributed or should be attributed only in part to the affiliatedcompanies. These companies would not charge for what they call "ad-ministrative", "managerial" or "parental" costs. Moreover, some com-panies do not keep separate records for the different types of costsincurred by the head offices.

Other groups follow cost allocation concepts without any distinction

133

as to the nature of service expenditures. They argue that it would notcorrespond to the economic realities to distinguish between costs, as allthe activities of the parent are performed in the interest and for the bene-fit of the entire group and, consequently, of all its members throughoutthe world. In their view, it would be artificial to separate out some typesof services, since what counts is the long-term performance of the trans-national group and the continuous stream of activities. Such groups arelikely to allocate all costs in proportion to the sales or the turnover ofthe respective affiliates or on some similar general basis. Some cost allo-cation systems are limited to services and related activities. Alternatively,the transnational enterprise may make a package deal, under which subsi-diaries pay a flat fee as a remuneration for the right to use patents, know-how, trade marks etc. and receive diverse services. A great variety ofcost-allocation systems and formulae are used in practice. Costs forcentral group activities may also be an element of calculation for the priceof goods delivered to subsidiaries. A profit mark-up may sometimes, butnot in all cases, be added to the costs.

4. The treatment of services for tax purposes

The successive steps involved for tax authorities are identifying thetype of service, determining whether the service has been rendered inpractice and then evaluating the arm's length remuneration appropriatein each case. Again, as with royalties, it is not suggested that an elaborateanalysis should be undertaken in every case, but the following considera-tions are relevant.

(a) A benefit testServices may be performed for the joint benefit of the members of a

transnational group or for the exclusive benefit of a member of the group.In the first case, a judgement will have to be made of the relative benefitsto each member concerned. It would be appropriate to consider the ben-efit intended at the time the service was rendered even if, in practice, itdid not fully materialize. But it would not be appropriate to regard abenefit as having been conferred if it was too indirect for unrelated partiesto be likely to have agreed to charge or to pay for similar services. Aservice which duplicates a service being performed by the related party,or which the latter is already having performed by a third party, wouldalso, on the face of it, not seem to provide a benefit for the related party.

In many cases, a useful pointer to the decision whether or not toaccept that a service has been rendered (or cost incurred) in the interestand for the benefit of a subsidiary may be the answer to the questionwhether, in similar circumstances, the service would be asked for or pro-vided where the parties were independent. It cannot be taken for grantedthat transnational enterprises should be able to recover the whole of theircentral expenses, including costs of control, on the grounds that all theseactivities benefit the affiliates and that in application of the arm's lengthprinciple in international tax law, these activities should be remunerated.Although some of the service activities of the parent company are onbalance imtended to, and do effectively, promote the performance of thegroup of related companies as a whole, this does not necessarily implythat such activities are rendered in the interest of the individual affiliated

134

members. They may be, but they may have a neutral or a negative effectin the case of one or another subsidiary. If, for example, the top manage-ment of a group decides that one subsidiary rather than another shouldget the order to construct a plant or to build a machine for a certaincustomer, or decides that one subsidiary rather than another should carryout certain research projects, or that a subsidiary should, for reasonsof group policy, buy its raw material in a more expensive market than itwould otherwise, then it may be reasonable to argue that some part atleast of the services provided by the parent had not provided a benefitfor the disadvantaged subsidiary. It is questionable, however, whetherit would often be worth while or appropriate to take the point.

(b) The substance of the serviceFor the service payment to be admitted by the tax authorities as an

allocable amount, it must not only qualify under the various aspects ofthe benefit test outlined above, but the service must be demonstrated tohave been rendered in practice. (This could include the provision of agenuine potential benefit in some cases even if the benefit did not in factmaterialize.)

If over a period a company cannot demonstrate the reality of theservices rendered, tax authorities will have grounds for refusing deduc-tion of any payment by the company (such as an annual flat fee) unlessit can be shown that similar contracts are concluded between unrelatedparties (for example, retainers entitling the payer to call for legal advice).

What would be deemed satisfactory evidence that a benefit has infact been conferred depends largely on the type of service rendered andthe circumstances of each case. Where a service payment is based oncosts, adequate books and records must be maintained by taxpayers topermit verification of such costs. The tax authorities would be helpedhere by evidence of written agreements where services on call or on re-quest are provided. Such agreements could cover the scope of the servicesto be remunerated and the definition of costs to be included, as well asthe method of remuneration. Supporting after-the-event evidence wouldinclude invoicing, individual evidence of costs incurred and evidence ofthe service flow.

Nevertheless, it is questionable to what extent it would be reason-able to require companies to keep elaborate records; much of the serviceprovided by companies to other companies in transnational groups isprovided on a continuing and informal basis which it would be impractic-able to seek to link closely with a formal calculation of the time spent inproviding it, and in many cases tax authorities may find it sufficient tomake an assessment of the appropriate charge as best they can in thelight of the available evidence.

(c) Arm's length pricingAs in other areas of intra-group transfers, the general principle to

be followed is that prices for services performed between related partiesshould be those which would be paid between independent companiesacting at arm's length. Consequently, such transactions should not betreated differently for tax purposes from similar transactions betweenindependent parties, simply because the companies happen to be affiliated.

135

It would follow from this that if the suggestion is made that specialcircumstances such as financial difficulties ought to justify the waiver ordeferral of payment, the question to be considered is whether there wouldbe waiver or deferral in similar transactions between unrelated com-panies. Exchange controls and similar restrictions should not be regardedas creating exceptions to the arm's length principle.

As to the form of payment, it would ordinarily be expected thatspecific services would be charged individually to the recipient of theservices. But payment by way of a flat fee for entitlement to services pro-vided automatically or continuously or at call may be met with and wouldbe acceptable if, under similar circumstances, unrelated parties wouldhave fixed the price in this manner.

The remuneration for services rendered to an affiliated entity maybe included in the price for other transfers. Thus, the price for licensinga patent or know-how may include a payment for technical assistanceservices performed for the licensee, or for managerial advice on the mar-keting of the goods produced under the license. In such cases tax au-thorities would have to check that there is no additional service feecharged and that a deduction is not allowed more than once.

In determining the amount of the consideration, under the arm'slength principle, it may be possible in many cases, especially where com-mercial and technical assistance were concerned, to make a comparisonwith prices charged between independent parties for similar transactions.With regard to administrative and managerial services, such comparisonsare likely to be more difficult; but similar transactions between unrelatedparties do occur. Where such evidence is lacking or is unsatisfactory, itmay be helpful to look at the price charged for services performed by theproviding company for unrelated parties-bearing in mind, however,the considerations involved in using this kind of evidence (see sect. Aabove).

5. Cost-oriented method

Frequently, it will not be possible to find a sufficiently similar openmarket transaction with which to compare the service fee agreed uponby related parties.

If a cost-oriented method is used it is necessary to decide:(a) Whether all costs, both direct and indirect, should be taken

into account, or merely direct costs;(b) Whether a profit mark-up should be included in addition to

the costs.Direct costs would include those identified specially with a particular

service, including, for example, the remuneration and travelling expensesof employees directly engaged in performing such services and expendi-ture on material and other supplies directly consumed in rendering theservices.

Indirect costs would include those which are not specifically iden-tified with a particular activity but which, nevertheless, are related to thedirect costs, including overhead costs relating to utilities (heating, light-ing, telephone etc.), occupancy (rents and maintenance of buildings etc.),supervisory and clerical remuneration, as well as other overhead burdens

136

of that part of the organization incurring the direct costs, an appropriateshare of the costs relating to supporting parts of the organization andother applicable general and administrative expenses, to the extent rea-sonably allocable to a particular service.

The basic question to ask must be what would happen in the arm'slength situation. Ordinarily an independent supplier of services could beexpected to charge what the market would bear and to seek to recoverall relevant costs. The general rule would therefore be that the chargeshould reflect all the relevant costs, both direct and indirect.

In the arm's length situation it would normally be expected that anindependent company would seek to charge for the services it providedin such a way as to recover not only its costs but also an element of profitand, in the case of affiliated companies, the general rule would thereforebe to expect the charge to be based on costs with a profit mark-up.

Clearly, if a main activity of the company is the business of pro-viding such services, then in the arm's length situation the company wouldseek to make a profit and in the case of affiliated companies a chargebased on cost plus a profit mark-up would be appropriate. But where acompany provided services which it was not a main part of its businessto provide, it may be argued that it would confine its charges to anamount which would recover the costs and no more. Some tax authoritieswould be prepared within limits to accept this argument.

It is perhaps unlikely, however, that a company in the arm's lengthsituation would provide services merely for cost, even if the provision ofsuch services was not a main part of its business, if it was particularlycapable of supplying the relevant services and the value of the services tothe recipient was considerably greater than the cost or if the cost of ser-vices represented a substantial proportion of the expenses of the recipi-ent's business. Tax authorities might therefore expect that where affiliatedcompanies are in the same situation the charge for the services wouldinclude a profit mark-up.

As to what should be the size of any profit mark-up in a cost-basedcalculation, little guidance is available. Something must clearly dependon the value of the services to the recipient but this may be very difficultto assess and in any case is not necessarily a very reliable guide; for ex-ample, the market rate chargeable by a plumber for mending a burst waterpipe would not ordinarily be very high, even though it covered all therelevant costs and included a profit element, but the repair could preventvery expensive damage causing a much greater loss to the recipient ofthe plumber's services. The real value of services concerning specializedtechnical or managerial assistance may in short not be related in a con-sistent manner to the costs involved. Also, it may often be very difficultto determine the direct and indirect costs actually related to a particularservice. Considerations of this sort may suggest that unless significantamounts of money are involved there may often be little to be gained inseeking to disturb a charge based on costs plus a modest mark-up oreven one based on costs alone.

Other considerationsIn some cases the over-all performance of a subsidiary to which

services have been rendered may give an indication whether the price

137

charged is appropriate or not, although it may be difficult to determinehow much of this performance is due to such service.

Generally, as in other areas of transfer pricing, it may be useful,where possible, to take account of more than one method in seeking asatisfactory approximation to the arm's length remuneration.

The considerations which have been discussed in the precedingparagraphs apply most fittingly to the pricing of individual or identifiedtransactions. However, some transnational groups apply special systemsfor allocating central costs to affiliates or use a package deal approachunder which affiliates pay an undifferentiated flat fee for a variety of rightsand services, possibly including the right to receive managerial, pro-fessional, accountancy or technical services as well as the right to usepatents, know-how or trade marks. Such arrangements may be moresatisfactory for them than attempts to put an exact price on specific ser-vices the value of which cannot easily be measured. The question for taxauthorities in dealing with arrangements of this sort is to determine howfar a real benefit is conferred on the payer and how far the payment canbe regarded as a reasonable approximation to the arm's length price. Inthis context the comments on cost contribution arrangements in the para-graphs dealing with payments for technology are relevant.

Withholding taxesIt is clear that whenever services are provided some cost to the sup-

plier must be involved and it follows from this that payments for servicescannot properly be regarded as net income payments and subjected to awithholding tax. In accordance with the OECD Model Double TaxationConvention they should be regarded as gross business receipts (whichmeans in consequence that they may enter into computation of the profitsof a permanent establishment of the providing entity where this isappropriate).

6. The treatment of loans for tax purposes

As regards transactions involving loans, it is assumed that thetreaty itself will contain articles relating to the following substantive as-pects: an article similar to the text of guideline 11, paragraph 6, in effectsaying that interest paid on a loan between related entities in excess ofthe interest that would be paid in the absence of the special relationshipbetween the payer and recipient shall not be governed by the other pro-visions of the article on "interest" and instead its treatment should be leftto domestic law supplemented by other provisions of the treaty; and anarticle similar in general to the text of guideline 9, paragraph 2, requiringthat transactions between associated enterprises (such as parent and sub-sidiary) be governed for tax purposes by an arm's length standard and acorrelative adjustment, a complementary provision requiring that appro-priate correlative adjustment is essential when either of the above pro-visions is applied. Hence, the profits of an enterprise may be adjustedupwards to reflect the profits that would have accrued to that enterpriseas judged by relations between independent enterprises.

Against the background of these substantive provisions, two prin-cipal problems arise. Seen from the point of view of the country of the

138

borrower, the interest stated in a loan contract or other debt arrangementbetween related entities, e.g., a parent and a subsidiary, may be exces-sive. As a consequence, the tax authorities of that country may seek todisallow the deduction for the excess interest in determining the tax li-ability of the debtor, perhaps treating the excess as a dividend whereappropriate. Seen from the point of view of the country of the lender,the interest stated in the loan contract may be too low. Such a situationmay in some cases be regarded as an effort to shift taxable profits awayfrom the country of the lender. As a consequence, the tax authorities ofthat country may seek in those cases to impute an appropriate interestcharge and thus increase the taxable profits of the lender to prevent sucha shift in profits. This adjustment will presumably in turn cause the bor-rower to seek a deduction in its country, under the correlative adjustmentclause, of the interest charge imputed to the creditor since, without suchdeduction, the related entities of creditor and borrower would togetherexperience double taxation.

In each situation-that of excessive interest and that of none or in-sufficient interest-the criterion involved is the principle of the arm'slength standard. Hence, each country is utilizing the same criterion. Butthe factor of which country initiates the use of the criterion will dependon whether the contract rate of interest is above or below the arm's lengthstandard and, along the same lines, whether it is the country of the bor-rower or that of the creditor which is as a consequence primarily affected.

Frequently, the creditor will be a parent corporation in a developedcountry and the borrower a subsidiary in a developing country. If this isso, the developing country in the typical adjustment case will be seekingto disallow a deduction for excess interest. The developed country, onthe other hand, typically will be seeking, in a case involving a shifting ofprofits, to impute a higher rate of interest than that contained in the con-tract. Clearly these situations cannot coexist in the same loan. Hence, itmust be that on some loans between related entities in developed anddeveloping countries the lenders for certain reasons are charging toomuch interest and on some loans, probably far fewer in number, they arecharging too little interest. However, it must be remembered that evenbetween developed countries these problems exist, and the tax authoritiesof even a developed country may be seeking to disallow excess interest.But situations of too little interest being charged by a parent in a develop-ing country (or a subsidiary in that country making a loan to a foreignparent) typically seem to arise rarely, largely because loans do not origi-nate in these countries.

It should be recognized that, in one sense, the question of intereston intercompany loans may be seen by some as an artificial matter inthat, from the point of view of the total profits of the group as a whole,the result is the same whether or not interest is charged. Hence companiesnot concerned with knowing the precise contribution of each componentof the group to the total profit may not be concerned about making aninterest charge on the company books on intercompany loans. However,since the use of money has a cost to a parent company, whether borrowedexternally or generated internally, companies concerned with an accuratereflection of the contribution of component units to the total profit willmake a charge on the company books for the use of money and hence

139

will charge interest on intercompany loans. The principle observationhere, however, is that company executives, from an internal companyviewpoint, may or may not be concerned about how a total profit is di-vided among the component units. But from the standpoint of taxauthorities this division is a crucial one, since the division of profitsdetermines the allocation between countries of the revenues making upthe total profit. Consequently, tax authorities cannot be content merelyto follow the treatment of intercompany loans on a company's books,since this would mean that tax authorities would be delegating revenuedecisions to book-keeping entries often made for particular purposes ofthe company and without regard to a fair division of the revenues be-tween the countries involved.

Hence, tax authorities are often compelled to separate a total multi-company profit into segments that attempt to reflect accurately the earn-ing power or profit contribution of the component within their owncountry. While this may seem to some an artificial or hypothetical task,it must be remembered that, as stated above, some companies are them-selves interested in really knowing what each separate component isactually earning and therefore accountants have developed rules for sodividing a total profit. Essentially, these rules are also based on the arm'slength standard and, in the case ot loans, require that in a normal situa-tion interest be chargeable to the borrower. In this sense, since loansbetween independent concerns do carry interest-lenders normally want-ing a return on their loans-loans between related entities also shouldnormally carry interest if the real profits being earned by the lender andborrower components of the related entities are a concern.

Thus, for tax purposes, it is proper to regard it as appropriate forparents to lend money to subsidiaries (and sometimes the other wayaround) and for such loans in a normal case to carry an interest charge.Hence, the basic inquiry is the determination of the appropriate charge.Under the guiding treaty provisions, this becomes a search for criteria toapply the substantive rule of the arm's length standard.

As stated above, the concern of tax authorities in developing coun-tries is to avoid a deduction for what they regard as excessive interestbeing charged to borrowers in their countries. Generally, the internal rateof interest in a developing country will be higher than the rate in thedeveloped country or in the world market. It would be appropriate toapply the arm's length standard by looking at the situation in the creditorcountry. In a sense, the image is that of an independent company in thedeveloping country being able to borrow externally under conditions thatwould primarily focus on the creditor's lending capacity and not on theconditions facing companies in the developing country forced to borrowin their internal market.

This being accepted, the question narrows to that of determiningwhat constitutes an appropriate rate viewed in the light of conditionsaffecting the creditor. Such conditions may involve factors such as thefollowing: Is the creditor obtaining its funds in its own market and whatis the general interest rate prevailing there, given the borrowing strengthof the creditor itself? Or is the creditor able to utilize a world market rateand is that rate a lower one? Generally speaking, it is probably appro-priate to use the general rate in the creditor country but to allow a higher

140

rate if the creditor's actual cost for money can be shown- to be higher (aswhere it paid a higher rate of interest to obtain the funds lent or therewere currency devaluation losses) or a lower rate if the creditor's actualcost can be shown to be lower (as when the creditor is in a position toborrow internationally from its Government at a favourable rate and isin a sense an intermediary in transmitting funds through a loan to thedeveloping country).

These may be useful criteria in fixing an arm's length standard andare susceptible of application on a case-by-case approach. Some com-petent authorities, however, may prefer to generalize these criteria andseek some rules of thumb in order to simplify administration. One possi-bility is to say that a developing country will not treat an interest chargeas excessive if the rate does not deviate significantly from the marketrate in the creditor country (except where the creditor can clearly provea higher actual cost), and even then will not concern themselves unlessthe amounts are substantial. Since this requires a determination of in-terest rates in the creditor country, the competent authorities for a par-ticular treaty could simplify administration by agreeing to a usual interestrate in the creditor country (this figure would have to be changed fromtime to time), and then agreeing to accept an interest charge, say, 20 percent above or below that figure. They could add that, in exceptional cir-cumstances where the amounts are significant, a higher figure could beaccepted where a higher actual cost to the creditor can be proved or, onthe other hand, a lower figure must be used where the creditor is knownto have received a preferential cost for money, for example, from a gov-ernment agency for the purpose of relending to a developing country.

It should be recognized that in many developing countries the matterof excess interest is removed from the hands of the tax authorities be-cause domestic law rules that exchange control authorities or investmentauthorities must approve the rate of interest to be charged by the creditorand the approved rate governs the contract for tax purposes as well.

Where a disallowance of excess interest is made by the borrowercountry, this step can require a correlative adjustment in the lender coun-try. Thus, if the excess interest is to be regarded as a disguised dividend,then presumably the parent should receive a foreign tax credit in thosecases in which such a credit is given for the corporate tax paid by thesubsidiary. The point, in effect, is that the aspect of correlative adjust-ment may occur in a developed country when the initial adjustment arisesin the developing country, the nature of the correlative adjustment de-pending upon the substantive issue involved.

The above relates to the competent authority administration of theexcess interest aspect, as set forth in guideline 11, paragraph 6, whichrelates to the borrower. But essentially the same considerations apply tocompetent authority administration of the arm's length standard of guide-line 9, paragraph 1, which relates to the creditor. Of course, the point-ofthe inquiry is different, since the tax authorities of the creditor countrymay be seeking to impute an interest charge where no interest is stated inthe loan contract between the related entities or where the stated interestis too low, so that a shifting of profits may be involved. But while thepoint of the inquiry is different, the standard to be followed, that of arm's

141

length, is the same as in the excess interest situation, and hence, thecriteria developed above are likewise applicable. In some countries, theimputed interest may be considered as a contribution or donation by theparent to the subsidiary, and the parent's income increased only to theextent that the amount of the interest exceeds a permissible limit on sucha donation.

As a consequence, if the tax authorities in a creditor country forimputation purposes use a rate focused on the rate in the creditor countryand for administrative convenience settle for a range on either side of thatrate, as discussed above, such a practice should as a general rule of thumbseem acceptable to the competent authority and tax authorities in a de-veloping country (or, in the process of correlative adjustment, perhapseven a developed country) where the borrower is located. Of course, asstated above, there may be exceptional cases and these can be dealt withas exceptions. Since the focus is on the rate in the creditor country, itwould seem proper for the competent authority of a developing countryto utilize one range as a rule of thumb in its consultative process with acompetent authority of developed country A and another range for de-veloped country B. This approach would not be inconsistent; rather, itwould reflect an understanding that conditions are different in countriesA and B.

It should be recognized that the discussion of the imputation of in-terest involves both guideline 9, paragraph 1, which allows imputation ofinterest to the creditor, and a treaty provision requiring a correlativeadjustment to reflect the imputed interest through a deduction in the taxliabilities of the borrower to avoid economic double taxation. But itshould be evident that, as a general matter, the criteria governing thededuction of interest under a correlative adjustment reflecting the imputa-tion in the creditor country are essentially the same criteria that governthe disallowance of excess interest when it is the borrower country thathas taken the initial step. In this light, it becomes understandable that theabsence of a charge for interest in the original loan contract should notprevent a later deduction for imputed interest, as the correlative adjust-ment, when interest is properly imputed by the tax authorities of thedeveloped country. (In reality, the portion of the correlative adjustmentclause overriding domestic law barriers to the adjustment would overridethe barrier that interest was not originally stated in the contract.) Thus,the fact that an excessively high rate of interest is stated in the contractdoes not bar the tax authorities of the borrower country from disallowingpart of that interest. Likewise, therefore, the fact that no interest or anexcessively low rate of interest is stated should bar neither imputationof interest nor deductibility of the imputed interest under a correlativeadjustment. Of course, a competent authority, in order to understand acase, may inquire as to why no interest was originally stated, just as itmay ask why a high rate of interest was originally stated.

It should be observed in this regard that the initial adjustment toimpute interest and the correlative adjustment to deduct that interest aretax computation matters and do not in themselves change the books ofthe related entities. The books may of course later be changed to reflectthe situation. This aspect is one of the secondary factors growing out ofthe initial and correlative adjustments.

142

The domestic law of some countries does not allow a deduction forinterest paid to a related foreign entity. Also, the domestic law of somecountries may adhere to the rule that, if a loan contract between relatedentities does not call for interest then, where the tax authorities in thelender country impute interest to prevent a shifting of profits, the bor-rower cannot obtain a deduction under a correlative deduction since thatwould be contrary to the original contract. Countries that desire to main-tain these domestic rules should therefore in their treaty negotiationsindicate the existence of these rules and frame the correlative adjustmentclause in accordance with them. This is thus a matter for negotiation inthe treaty itself.

The initial adjustment imputing interest and a correlative adjustmentallowing a deduction for interest may not complete the process of ad-justment. The imputed interest may also give rise to a withholding tax onsuch interest if the country of the related entity has such a tax. The timeof imposition of that tax and the amount of the tax will depend on therules applicable to the withholding tax, including any treaty provisionsrelating to that tax. Of course, there may be a variety of instances inwhich loans or debt obligations are made without an interest charge andit is proper not to alter that arrangement to impute interest. Substantivelythese are situations in which it can be said that, because of the particularfactors involved, even a creditor lending to an independent or unrelatedentity would not require interest. Trade credits, including sales on a de-ferred payment basis, between parent and subsidiary may be carriedwithout an interest charge if the parent would customarily do so with in-dependent customers, or if the commercial practice in the creditor'scountry is not to charge interest on such credits depending on the timeperiod involved. As another example, if a subsidiary is in financial diffi-culties and an interest-free loan is made by the parent, it would be appro-priate not to charge interest if independent companies in such a situationwould forgo interest in an effort to sustain the debtor company, as whena supplier may seek to aid a valued customer. Still another example wouldbe the situation of start-up losses at the beginning of a subsidiary's exis-tence. The point is not that such trade credits, financial difficulties orstart-up losses are in themselves absolute factors that deny imputationof interest. Instead they are factors that clearly can occasion an inquiryas to whether in an independent setting these factors would be regardedas sufficient reason for not charging interest and therefore can supportthe explanation of a parent as to why its loan did not carry interest undersuch circumstances. Indeed, it is quite likely that these situations takentogether may well represent a large number of the cases in which parentcompanies in developed countries do not charge interest on loans to sub-sidiaries in developing countries. Assuming that "no interest" cases existbetween developed and developing countries to any appreciable extent,the occasion for imputation of interest may be considerably reduced be-tween developed and developing countries.

As another aspect of the matter of a tax adjustment in the creditorcountry when a loan is interest-free, some countries under their domesticlaw do not impute interest, even though the absence of interest is rec-ognized as improper under an arm's length standard, but instead disallowas a deduction the expense involved in obtaining the funds represented

143

in the loan. However, the two approaches-imputation of interest ordisallowance of expense-will not automatically reach the same final re-sult. Thus, if it is assumed that the interest imputed to a parent wouldbe 100 and the expense disallowed under the disallowance approachwould also be 100, the net effect on the parent's taxable profit of eitheradjustment would be the same-the taxable profit would increase by100. (This assumes that it is always possible to ascertain the expensesinvolved in funding the loan, even where the loan is made from the in-ternal funds of the parent. If this is not so, the disallowance of expenseapproach is likely to result in a smaller amount than would be the amountadded under an imputation approach and hence the latter approach couldresult in a higher taxable profit on the parent's side.) But, under theexpense disallowance approach, how is a correlative adjustment to becarried out? Unless it is considered appropriate for the subsidiary to re-imburse the parent for the expense disallowance, there may be no way toalter the tax computation of the subsidiary. Yet if this is so, economicdouble taxation is the result, since the parent's taxable income will riseby 100 and the subsidiary's taxable income will remain the same, thoughit reflects the interest-free loan (and hence is 100 higher than would occurunder an arm's length standard). It is thus clear that the expense dis-allowance method results in economic double taxation unless a correlativeadjustment is made.

Further, if interest is not imputed, the opportunity to impose a with-holding tax in the country of the subsidiary may not be so readily ap-parent. Indeed, the imposition of such a tax may depend on whether thecountry of the subsidiary regards the disallowed expense of the parentas in effect an "interest" cost of the subsidiary. Also, if the parent's coun-try uses a foreign tax credit r6gime and if no correlative adjustment ismade, the matter may end up with a higher foreign tax credit claimed bythe parent, which is an improper result. The final determination of thecredit amount will, however, depend on several factors, such as the ap-plication of the limitation on income from foreign sources and the methodof its calculation. If such a correlative adjustment is made and a with-holding tax applied where appropriate, the consequences of the two ap-proaches would appear to be the same. Yet it should be clear that thesubsidiary country may conceptually find it more difficult to make thecorrelative adjustment and apply a withholding tax in an expense dis-allowance context.

All of the above discussion assumes that a real loan is involved.However, an important area of difficulty exists in determining whether atransmission of funds from a parent to a subsidiary is a loan transactionor an equity transaction, that is, a contribution to the capital of thesubsidiary. If it is an equity transaction, then payments on the purported"loan" are really not interest but dividends and hence are not deductiblein computing the subsidiary's tax (unless regular dividends are deductibleunder domestic law). Also, if the "loan" is really an equity transactionand a contribution to capital, it is not proper to impute interest. Hence,the classification of the transaction as debt or equity is a crucial matter.

The problem of classification can be difficult to solve. As a first step,it can generally be said that, for a loan to exist, the related entities shouldcharacterize the transaction as a loan and should give it the aspect of a

144

loan, such as an unconditional promise to pay a fixed amount of principalat a fixed maturity date. But the fact that the related entities call thetransaction a loan and give it the aspects of a loan does not in itself an-swer the question of classification. It is the reality of the situation and notjust its characterization as a loan that determines the final classification.

The mere fact that a parent-subsidiary relationship is involved doesnot in itself bar a real loan from existing if the transaction may otherwisevalidly be regarded as a loan. However, since a parent which is the soleowner of a subsidiary is in a position either to make a contribution tocapital or to make a loan-a situation in which an independent creditorwould not normally be-the very option possessed by the parent makesit all the more necessary that its choice be carefully scrutinized on a caseby case basis. When circumstances limit such an option for the parent,as when it is only one participant in a joint venture or there are significantminority shareholders, the presence of such outside parties with financialpositions that may differ from the parent can affect the situation.

It appears to be generally accepted that no definite rules of thumbare available to decide this matter of classification. Of course, in somecountries the classification as debt or equity may be made by the ex-change authorities or other authorities under domestic law when the in-vestment is permitted to be made, and this determination may underdomestic law govern the tax situation or so shape the investment thatthe issue will not arise. But where this is not so, in all likelihood the taxauthorities and ultimately the competent authorities will have to proceedcase by case.

In so proceeding they can, of course, develop certain criteria orfactors that they will take into consideration. For example, the competentauthorities may wish to consider such questions as: Is the capitalizationtoo "thin"? Does the debt-equity ratio of the borrower company show amuch higher amount of debt than in the case of other companies engagedin similar businesses? Is the debt convertible into stock of the borrower?Is the debt subordinated to the rights of other creditors? Does the absenceof interest over a period of time indicate that a debt was really not in-tended? Was a failure of the borrower to pay interest or principal whendue overlooked by the creditor, or did the creditor fail to press hard forpayment? Answers to such questions may point to an equity contributionrather than to a loan or debt obligation. Also, it may be that what is reallyequity is disguised as a loan to manoeuvre around exchange or otherrestrictions.

When the competent authorities find that the transaction is reallynot a loan but an equity transaction, the country of the borrower maydisallow a so-called interest payment as a deduction or, if no interest hasbeen charged, it may decide it would not be appropriate to impute in-terest. It may be that many transactions involving related entities betweendeveloped and developing countries are situations in which an equitytransaction or contribution to capital has been disguised as a loan. Insuch cases, the competent authorities should give the transaction the taxtreatment it would receive if properly characterized as an equity trans-action.

145

III. SUGGESTED ARRANGEMENTS BETWEENTREATY COMPETENT AUTHORITIESREGARDING EXCHANGE OF INFORMATION

In negotiating treaties for the avoidance of double taxation and taxevasion the competent authorities might wish to provide for the exchangeof such information as is necessary for carrying out the provisions of thetreaty or of the domestic laws of the Contracting States concerning taxescovered by the treaty. In this regard, the following are suggested guide-lines for arrangements regarding the implementation of appropriate ex-changes of information. They are in the form of an inventory of possiblearrangements from which the competent authorities under a tax treatymay select the particular arrangements which they decide should be uti-lized. The inventory is not intended to be exhaustive nor is it to be re-garded as listing matters all of which are to be drawn on in every case.Instead, the inventory is a listing of suggestions to be examined by com-petent authorities in deciding on the matters they wish to cover.

A. ROUTINE TRANSMITTAL OF INFORMATION'

A method of exchange of information that is in use to a limited extentis that of the routine or automatic flow of information from one treatycountry to another. The following are various aspects that the competentauthorities should focus on in developing a structure for such routineexchange. In considering routine exchanges of information it should berecognized that some countries not desiring to receive such informationin a routine fashion (or unable to receive it routinely because the trans-mitting countries do not routinely collect such information) may desireto obtain information of this type under a specific request. Hence, in thesesituations, items mentioned in the present section should be consideredas available for coverage under the next section, "Transmittal on specificrequest".

1. Items covered

Regular sources of income

The items covered under a routine transmittal or exchange of in-formation may extend to regular sources of income flowing betweencountries, such as dividends, interest, compensation (including wages,salaries, fees and commissions), royalties, rents and other possible itemswhose regular flow between the two countries is significant. It should berecognized, however, that at present most countries are not in a positionto supply routine information of this type because their tax collectionprocedures do not provide the needed data.

1 In the following, "transmitting country" refers to the country transmittinginformation and "receiving country" refers to the country receiving information.

146

Transactions involving taxpayer activity

A routine exchange of information may cover certain significanttransactions involving taxpayer activity.

(a) Transactions relevant to the treaty itself:Claims for refund of transmitting country tax made by residents of

receiving country;Claims for exemption or particular relief from transmitting country

tax made by residents of receiving country.

(b) Transactions relevant to special aspects of the legislation of thetransmitting country:

Items of income derived by residents of the receiving country thatreceive exemption or partial relief under special provisions of the nationallaw of the transmitting country.

(c) Transactions relating to activities in the transmitting countryof residents of the receiving country;

Opening and closing by receiving country residents of a branch,office etc. in the transmitting country;

Creation or termination by receiving country residents of a corpora-tion in the transmitting country;

Creation or termination by receiving country residents of a trust inthe transmitting country;

Opening and closing by receiving country residents of bank accountsin the transmitting country;

Property in the transmitting country acquired by residents of thereceiving country by inheritance, bequest or gift;

Ancilliary probate proceedings in the transmitting country concern-ing receiving country residents.

(d) General information:Tax laws, administrative procedures etc. of the transmitting country;Changes in regular sources of income flowing between countries,

especially as they affect the treaty, including administrative interpreta-tions of and court decisions on treaty provisions and administrative prac-tices or developments affecting application of the treaty;

Activities that effect or distort application of the treaty, includingnew patterns or techniques of evasion or avoidance used by residents ofthe transmitting or receiving country;

Activities that have repercussions regarding the tax system of thereceiving country, including new patterns or techniques of evasion oravoidance used by residents of either country that significantly affect thereceiving country's tax system.

2. General operational aspects to be considered

The competent authorities should consider various factors that canbear on the operational character of the routine exchange, including itseffectiveness, such as:

147

(a) Countries that are more interested in receiving information ona specific request basis than on a routine basis, in their consideration ofthe specific request area, should keep in mind items mentioned in thisinventory under the heading of routine information;

(b) A minimum floor amount may be fixed to limit minor data;(c) The routine source of income items may be rotated from year

to year, e.g., dividends only in one year, interest in another, etc.;(d) The information to be exchanged routinely need not be strictly

reciprocal in all items. Country A may be interested in receiving infor-mation on some items but not others; the preferences of country B mayextend to different items. It is not necessary for either country to receiveitems in which it is not interested. Nor should either country refuse totransmit information on certain items simply because it is not interestedin receiving information on those items;

(e) While the information to be exchanged on income items maynot always be significant in itself as regards the income flows escapingtax, the routine exchange may provide indications respecting the degreeto which the capital or other assets producing the income flows are escap-ing tax;

(f) Whether the information as to income items should cover onlythe payee or also the payer;

(g) Whether the information should cover only residents of thereceiving country or also those domiciled therein or citizens thereof, or belimited to any of these categories;

(h) The degree of detail involved in the reporting, e.g., name oftaxpayer or recipient, profession, address, etc.;

(i) The form and the language in which the information should beprovided.

3. Factors to be considered by the transmitting country

The transmitting country may desire to give consideration to factorsaffecting its ability to fulfil the requirements of a routine exchange ofinformation. Such a consideration would presumably lead to a more care-ful selection of the information to be routinely exchanged rather than to adecision not to exchange information which will be of practical use.

Among the factors to be considered are the administrative ability ofthe transmitting country to obtain the information involved. This in turnis governed by the general effectiveness of its administrative procedures,its utilization of withholding taxes, its utilization of information returnsfrom payers or others and the over-all costs of obtaining the informationinvolved.

4. Factors to be considered by receiving country

The receiving country may desire to give consideration to factorsaffecting its ability to utilize the information that could be received undera routine exchange of information, such as the administrative ability ofthe receiving country to use the information on a reasonably current basisand effectively to associate such information with its own taxpayers, either

148

routinely or on a sufficient scale to justify the routine receipt of theinformation.

B. TRANSMITTAL ON SPECIFIC REQUEST

A method of exchange of information that is in current use is thatof a request for specific information made by one treaty country to an-other. The specific information may relate to a particular taxpayer andcertain facets of his situation or to particular types of transactions oractivities or to information of a more general character. The followingare various aspects that the competent authorities should focus on in de-veloping a structure for such exchange of information pursuant to specificrequests.

1. Items covered

Particular taxpayersThe information that may be desired from a transmitting country

with respect to a receiving country taxpayer is essentially open-ended anddepends on the factors involved in the situation of the taxpayer underthe tax system of the receiving country and the relationship of the tax-payer and his activities to the transmitting country. A specific enumera-tion in advance of the type of information that may be within the scopeof an exchange pursuant to specific request does not seem to be a fruitfulor necessary task. The agreement to provide information pursuant tospecific request may thus be open-ended as to the range, scope and typeof information, subject to the over-all constraints to be discussed herein.

The request for specific information may arise in a variety of ways.For example:

(a) Information needed to complete the determination of a tax-payer's liability in the receiving country when that liability depends onthe taxpayer's world-wide income or assets; the nature of the stock owner-ship in the transmitting country of the receiving country corporation; theamount or type of expense incurred in the transmitting country; the fiscaldomicile of an individual or corporation;

(b) Information needed to determine the accuracy of a taxpayer'stax return to the tax administration of the receiving country or the accu-racy of the claims or proof asserted by the taxpayer in defence of the taxreturn when the return is either regarded as suspect or under actualinvestigation;

(c) Information needed to determine the true liability of a tax-payer in the receiving country when it is suspected that his reported li-ability is wrong.

Particular types of transactions or activities

The exchange on specific request need not be confined to requestsregarding particular taxpayers but may extend to requests for informationon particular types of transactions or activities. For example:

(a) Information on price, cost, commission or other such patternsin the transmitting country necessary to enable the tax administration ofthe receiving country either to determine tax liability in a particular sit-

149

uation or to develop standards for investigation of its taxpayers in situa-tions involving possible under- or over-invoicing of exported or importedgoods, the payment of commissions on international transactions and thelike;

(b) Information on the typical methods by which particular transac-tions or activities are customarily conducted in the transmitting country;

(c) Information as to whether a particular type of activity is beingcarried on in the transmitting country that may have effects on taxpayersor tax liabilities in the receiving country.

Economic relationships between the countriesThe specific request may extend to requests for information regard-

ing certain economic relationships between the countries which may beuseful to a country as a check on the effectiveness of its tax administra-tion activities. For example:

(a) Volume of exports from the transmitting country to the receiv-ing country;

(b) Volume of imports into the transmitting country from the re-ceiving country;

(c) Names of banks dealing in the transmitting country withbranches, subsidiaries, etc. of r~sidents of the receiving country.

It should be noted that since items in this category, such as thevolume of exports between the countries, are presumably not regarded assecret to the tax authorities in the transmitting country, they may be dis-closed generally in the receiving country, as guideline 26 provides.

2. Rules applicable to the specific request

The competent authorities should develop rules applicable to thetransmission of specific requests by the receiving country and to the re-sponse by the transmitting country. These rules should be designed tofacilitate a systematic operational procedure regarding such exchangethat is efficient and orderly. While the rules may be general in characterin the sense that they set standards or guidelines governing the specificrequest procedures, the rules should also permit discussion between thecompetent authorities of special situations that either country believesrequire special handling.

The rules should pertain to:(a) The specificity of detail required in the request by the receiving

country, the form of such request and the language of the request andreply;

(b) The extent to which the. receiving country must pursue or ex-haust its own administrative processes and possibilities before making aspecific request; presumably the receiving country should make a bonafide effort to obtain the information for itself before resorting to the spe-cific request procedure;

(c) The conditions affecting the nature and extent of the responseby the transmitting country. This aspect should cover the ability of thetransmitting country to provide documentary material when the receiving

150

country needs material in that form for use in judicial or other proceed-ings, including the appropriate authentication of the documents.

C. TRANSMITTAL OF INFORMATION ON DISCRETIONARYINITIATIVE OF TRANSMITTING COUNTRY

The competent authorities should determine whether, in addition tothe routine and specific request methods of exchange of information underwhich a transmitting country is automatically transmitting information orsystematically responding to specific requests by the receiving country, theydesire a transmittal of information on the discretionary initiative of thetransmitting country itself. Such a transmittal could occur when, in thecourse of its own activities, the tax administration of the transmittingcountry obtains information that it considers would be of importance tothe receiving country. The information may relate to facets of a particulartaxpayer's situation and the relationship of that situation to his liability inthe receiving country or to the liability of other taxpayers in the receivingcountry. Or the information may relate to a pattern of transactions orconduct by various taxpayers or groups of taxpayers occurring in eithercountry that is likely to affect the tax liabilities or tax administration ofthe receiving country either in relation to its national laws or to the treatyprovisions.

The competent authorities will have to determine, under the stan-dards governing the exchange of information developed pursuant to thetreaty, whether it is the duty of a transmitting country affirmatively todevelop a procedure and guidelines governing when such information isto be transmitted, or whether such transmittal is to be considered by thetransmitting country but is fully discretionary, or whether such transmittalneed not even be considered by the transmitting country. Even if it isagreed that it is the duty of the transmitting country to develop a systemfor such transmittal, presumably the decision on when the conditionsunder that system have been met would rest on the discretionary judg-ment of the latter country.

D. USE OF INFORMATION RECEIVED

The competent authorities will have to decide on the permissible useof the information received. The decisions on this matter basically dependon the legal requirements set forth in guideline 26 itself. Under the guide-line the extent of the use of information depends primarily on the require-ments of national law regarding the disclosure of tax information or onother "security requirements" regarding tax information. This being so,it is possible that the extent of the disclosure or the restrictions on dis-closure may vary between the two countries. However, such possiblevariance need not be regarded as inappropriate or as negating exchangesof information that would otherwise occur if the countries involved aresatisfied with such a consequence under guideline 26 as adopted in theirconvention.

1. Recipients of information received through exchange

The competent authorities will have to specify, either in detail orby reference to existing comparable rules in the receiving country, who

151

are the qualifying recipients of information in that country. Under guide-line 26 the information can be disclosed, for example:

(a) To administrators of the taxes covered in the convention;(b) To enforcement officials and prosecutors for such taxes;(c) To administrative tribunals for such taxes;(d) To judicial tribunals for such taxes;(e) In public court proceedings or in judicial decisions where it

may become available to the public if considered appropriate;(f) To the competent authority of another country (see sect. E

below).

2. Form in which information is provided

The permissible extent of the disclosure may affect the form in whichthe information is to be provided if it is to be useful to the receivingcountry. Thus, if the information may be used in judicial tribunals and if,to be so used, it must be of a particular character or form, then the com-petent authorities will have to consider how to provide for a transmittalthat meets this need. (See also the comment on documents under sect.B.2 above.)

E. CONSULTATION AMONG SEVERAL COMPETENT AUTHORITIES

Countries may desire to give consideration to procedures developedby the competent authorities for consultations covering more than thetwo competent authorities under a particular treaty. Thus, if countries A,B and C are joined in a network of treaties, the competent authorities ofA, B and C might desire to hold a joint consultation. This could be de-sired whether all three countries are directly intertwined, for example,where there are A-B, A-C and B-C treaties, or where one country is alink in a chain but not fully joined, for example, where there are A-Band B-C treaties but not an A-C treaty. Countries desiring to have theircompetent authorities engage in such consultations should provide thelegal basis for the consultations by adding the necessary authority in theirtreaties. Some countries may feel that guideline 26 permits joint con-sultation where all three countries are directly linked by bilateral treaties.However, the guideline does not cover joint consultation where a linkin the chain is not fully joined, as in the second situation described above.In such a case, it would be necessary to add a treaty provision allowingthe competent authority of country B to provide information receivedfrom country A to the competent authority of country C. Such a treatyprovision could include a safeguard that the competent authority of coun-try A must consent to the action of the competent authority of country B.Presumably, it would so consent only where it was satisfied as to the pro-visions regarding protection of secrecy in the B-C treaty.

F. OVER-ALL FACTORS

There are a variety of over-all factors affecting the exchanges ofinformation that the competent authorities will have to consider anddecide upon, either as to their specific operational handling in the imple-

152

mentation of the exchange of information or as to their effect on theentire exchange process itself. Among such over-all factors are:

1. Factors affecting implementation of exchange of information

(a) The competent authorities should decide on the channels ofcommunication for the different types of exchanges of information. Onemethod of communication that may be provided for is to permit an offi-cial of one country to go in person to the other country to receive theinformation from the competent authority and discuss it so as to expeditethe process of exchange of information.

(b) Some countries may have decided that it is useful and appro-priate for a country to have representatives of its own tax administrationstationed in the other treaty country. Such an arrangement would pre-sumably rest on authority, treaty or agreements other than that in thearticle on exchange of information of the envisaged double taxationtreaty (though, if national laws of both countries permit, this articlewould be treated as covering this topic) and the arrangement would de-termine the conditions governing the presence of such representativesand their duties. In this regard it should be noted that it would not seemnecessary that the process be reciprocal, so that it would be appropriatefor country A to have its representatives in country B but not vice versaif country A considered the process to be useful and country B did not.If arrangements do exist for such representatives, then the competentauthorities may want to co-ordinate with those representatives wheresuch co-ordination would make the exchange of information processmore effective and where such co-ordination is otherwise appropriate.

(c) Some countries may decide it is appropriate to have a tax of-ficial of one country participate directly with tax officials of the othercountry in a joint or "team" investigation of a particular taxpayer oractivity. The existence of the arrangement for most countries would pre-sumably rest on authority, treaty or agreements other than that in theenvisaged treaty article on exchange of information, although, if nationallaws of both countries permit, this article could be treated by the coun-tries as authorizing the competent authorities to sanction this arrange-ment. In either event, if the arrangement is made, it would be appropriateto extend to such an investigation the safeguards and procedures de-veloped under the envisaged treaty article on exchange of information.

(d) The process of exchange of information should be developedso that it has the needed relevance to the effective implementation of thesubstantive treaty provisions. Thus, treaty provisions regarding intercom-pany pricing and the allocation of income and expenses produce their owninformational requirements for effective implementation. The exchangeof information process should be responsive to those requirements.

(e) The substantive provisions of the treaty should take accountof and be responsive to the exchange of information process. Thus, if thereis an adequate informational base for the exchange of information pro-cess to support allowing one country to deduct expenses incurred in an-other country, then the treaty should be developed on the basis of thesubstantive appropriateness of such deduction.

(f) The competent authorities will have to determine to what ex-

153

tent there should be cost sharing or cost reimbursement with respect tothe process of exchange of information.

2. Factors affecting structure of exchange of information process

(a) It should be recognized that the arrangements regarding ex-change of information worked out by country A with country B need notparallel those worked out between country A and country C or betweencountry B and country C. The arrangements should in the first instancebe responsive to the needs of the two countries directly involved and neednot be fully parallel in every case just for the sake of formal uniformity.However, it should be observed that prevention of international tax eva-sion and avoidance will often require international co-operation of taxauthorities in a number of countries. As a consequence, some countriesmay consider it appropriate to devise procedures and treaty provisionsthat are sufficiently flexible to enable them to extend their co-operationto multicountry consultation and exchange arrangements.

(b) The competent authorities will have to weigh the effect of adomestic legal restriction on obtaining information in a country that re-quests information from another country not under a similar domesticlegal restriction. Thus, suppose country A requests information fromcountry B and the tax authorities in country B are able to go to theirfinancial institutions to obtain such information whereas the tax authori-ties in country A are generally not able to go to their own financial in-stitutions to obtain information for tax purposes. How should the matterbe regarded in country B? It should be noted that guideline 26 permitscountry B to obtain the information from its financial institutions andtransmit it to country A. Thus, country B is not barred by its domesticlaws regarding tax secrecy if it decides to obtain and transmit the infor-mation. It thus becomes a matter of discretion in country B as to whetherit should respond, and may perhaps become a matter for negotiation be-tween the competent authorities. It should be noted that many countriesin practice do respond in this situation and that such a course is indeeduseful in achieving effective exchange of information to prevent taxavoidance. However, it should also be noted that country A, being anxiousto obtain information in such cases from other countries, should alsorecognize its responsibility to try to change its domestic laws to strengthenthe domestic authority of its own tax administration and to enable it torespond to requests from other countries.

(c) In addition to situations involving the legal imbalance dis-cussed above, the competent authorities will have to weigh the effects ofa possible imbalance growing out of a divergence in other aspects of taxadministration. Thus, if country A cannot respond as fully to a requestas country B can because of practical problems of tax administration incountry A, then might the level of the process of exchange of informationbe geared to the position of country A? Or, on the other hand, in generalor in particular aspects, should country B be willing to respond to re-quests of country A even when country A would not be able to respondto requests of country B? This matter is similar to that discussed in thepreceding paragraph and a similar response should be noted.

(d) It should be noted that guideline 26 authorizes a transmitting

154

country to utilize its administrative procedures solely to provide informa-tion to the requesting country, even when the person about whom in-formation is sought is not involved in a tax proceeding in the transmittingcountry. Moreover, the transmitting country can, for the purpose of ex-change of information, utilize its own administrative authority in thesame way as if its own taxation were involved.

(e) The competent authorities will have to weigh the effect on theprocess of exchange of information of one country's belief that the taxsystem or tax administration of the other country, either in general or inparticular situations, is discriminatory or confiscatory. It may be thatfurther exploration of such a belief could lead to substantive provisionsin the treaty or in national law that would eliminate the problems per-ceived by the first country and thereby facilitate a process of exchange ofinformation. One possible example of this is the treatment of non-permanent residents.

(f) The competent authorities will have to weigh the effects thatthe process of exchange of information may have on the competitive posi-tion of taxpayers of the countries involved. Thus, if country A has a treatywith country B providing for exchange of information, country A willhave to weigh the effect on the structure or process of that exchange ofthe fact that country C does not have a treaty with country B, so that firmsof country C doing business in country B may be subject to a differenttax posture in country B than firms of country A. Similarly, even if atreaty with an exchange of information article exists between countries Cand B, if the tax administration of country A has more authority to obtaininformation (to be exchanged with county B) than does the tax adminis-tration of country C, or is otherwise more effective in its administrationand therefore has more information, then a similar difference in tax pos-ture may result. As a corollary, it seems clear that the adequate imple-mentation of exchange of information provisions requires a universaleffort of tax administrations to obtain and develop under national laws acapacity for securing information and a competence in utilizing informa-tion that is appropriate to a high level of efficient and equitable taxadministration.

3. Periodic consultation and review

Since differences in interpretation and application, specific difficul-ties and unforeseen problems and situations are bound to arise, provisionmust be made for efficient and expeditious consultation between the com-petent authorities. Such consultation should extend both to particularsituations and problems and to periodic review of the operations underthe exchange of information provision. The periodic review should en-sure that the process of exchange of information is working with the re-quisite promptness and efficiency, that it is meeting the basic requirementsof treaty implementation and that it is promoting adequate compliancewith treaty provisions and the national laws of the two countries.

155

IV. PROCEDURAL ASPECTS OF TAXTREATY NEGOTIATIONS

The procedural aspects of negotiating a tax treaty include the iden-tification of the need for a treaty, the establishment of contracts with apotential treaty partner, the appointment of a delegation, the preparationsfor negotiations, the conduct of the negotiations and procedures for bring-ing the treaty into force.

A. IDENTIFICATION OF THE NEED FOR A TREATY

In determining whether a need exists for a tax treaty with a particu-lar country, it is first necessary to examine the nature and extent of theexisting economic relationship between the two countries as well as thepotential and desire for growth in that relationship. Secondly, the extentto which the interrelationships between the tax systems of the two coun-tries may inhibit the economic relationships should be examined. Theseinhibiting effects may be reflected, for example, in excessively high levelsof tax on international income flows, inadequate statutory relief fromdouble taxation, and conflicting definitions of terms or concepts. Thirdly,it is desirable to determine whether and to what extent and for what rea-sons the tax systems of the two countries result in actual or virtual doubletaxation.

B. INITIAL CONTACTS

Once the need for entering into a treaty with a particular countryhas been identified, the desire to open negotiations must be communicatedto the other country. As a general rule, such contacts are made initiallythrough diplomatic channels. It is helpful, however, where a personalrelationship exists between tax officials in the two countries, that thisrelationship should be utilized and the official diplomatic contacts shouldbe supplemented by contacts through these channels on a less formalbasis.

Where necessary, this initial contact phase may be the appropriatetime to request information or other materials on the tax system and taxtreaties of the other country.

C. APPOINTMENT OF A DELEGATION

A delegation typically consists of three to five individuals, thoughthis is by no means a hard and fast rule.

The leader of the delegation should be a senior official with taxpolicy responsibility who has the authority to make independent policydecisions, at least on a tentative basis.

The members of the delegation should be individuals who, amongthem, combine most of or all the following skills:

156

(a) Familiarity with the administrative aspects of tax treaties andwith the administration of the international aspects of internal law. Anindividual having such familiarity would, in effect, represent the com-petent authority function on the delegation;

(b) A lawyer who is familiar with domestic tax law and able to drafttreaty provisions;

(c) An economist or other individual with an understanding of theeconomic relationships between the two countries and an ability to assessthe economic impact of the decisions being made in the course of thenegotiations.

If negotiations are to be held in the home capital, the opportunitymay be taken to bring others into the negotiations for training purposes.If this is to be done, however, care should be exercised to keep the dele-gations from becoming so big as to "over-power" the visiting delegation.

Finally, it is most important that one member of the delegation beassigned the clear responsibility for taking careful notes of the discussions.

D. PREPARATIONS FOR NEGOTIATIONS

Members of the delegation should participate, possibly along withothers, in preparing for the negotiations. The preparations typically in-clude the following steps:

(a) The tax system of the other country and its existing tax treatiesmust be studied. The other treaties provide an indication of the range ofpositions acceptable to the other country;

(b) A draft treaty or working paper should be prepared showinginitial positions on the major issues in a tax treaty. This may be in generalform, to be used for all treaty discussions, or it may be geared to theparticular discussions being undertaken. This draft should then be trans-mitted to the other delegation. Though this step is useful for advising theother delegation of positions to be taken in the negotiations, it is alsouseful for the members of the delegation which prepares it, in requiringthem to focus clearly on their own positions;

(c) If the other delegation has prepared a similar draft or workingpaper the two should be compared and positions should be prepared onall points of difference;

(d) In working out a country's position the following groupsshould be sounded out to suggest issues from their own experience: (i) thebusiness community in the country; (ii) that country's subjects who arein the other country (the country's embassy in the other country cancarry out this function); and (iii) other government agencies (e.g., invest-ment agencies, government marketing boards etc.);

(e) It is most useful if at least one member of the delegation isfamiliar with the United Nations guidelines, the OECD model convention,the Mexico and London draft model conventions and any relevant re-gional model treaties.

E. ARRANGEMENTS FOR MEETINGS BETWEEN NEGOTIATINGDELEGATIONS

Experience has shown that negotiations typically require at least two

157

rounds of discussions, sometimes more, which are usually held on analternating basis in the two capitals.

It is common experience that one week is an optimal length for around of discussions. By the end of a week there is usually an accumula-tion of issues which require careful consideration in capitals with prin-cipal officials before final decisions can be made. Furthermore, as a purelypractical matter, officials frequently find that the amount of work thatpiles up on their desks during the discussions can become intolerablewhen treaty discussions extend more than a week at a time.

In arranging for the meetings, the host delegation should make cer-tain that: (a) there is a common language for negotiations or (b) thatinterpreters will be available who can deal with tax concepts and ter-minology in both languages.

F. CONDUCT OF THE NEGOTIATIONS

1. The first round of negotiations

It is helpful, as a first order of business, to make certain that eachside understands the tax system of the other, particularly as it relates tothe taxation of international income flows. If there are particularly com-plex aspects of a country's tax law which are relevant for a tax treaty, itis often helpful for that country to prepare a brief explanation in writtenform for the other delegation.

Once there is a general understanding of the two tax systems, thenegotiations themselves can begin by means of an article-by-article reviewof the draft or drafts previously prepared. If neither side has its ownmodel or draft, the United Nations guidelines can be used for this pur-pose. During this initial article-by-article review, agreement can bereached on a number of relatively easy points and a clarification and, insome cases, a narrowing of the differences can be achieved on the remain-ing points.

If time remains after concluding one complete review of the draft, asecond article-by-article review can be begun. At this point, greater effortshould be devoted to reaching agreement.

At the conclusion of the week's discussions, it is useful to prepare anagreed statement of the open issues and, if possible, to schedule the nextmeeting.

2. Between the first and second rounds of the negotiations

It should be agreed at the conclusion of the first round that one sidewill retype a draft showing agreed language and, by use of brackets andalternative language or other suitable symbols, the open issues. Thisdocument would then become the discussion draft for the second round.

It is important that the notes of the discussions be recorded anddistributed to members of the delegations as quickly as possible, whilememories are still fresh, particularly if there is more than one treatyunder negotiation at the time.

Between the two rounds, the heads of the delegations should cor-

158

respond to exchange drafts, to indicate tentative conclusions on majoropen issues and to confirm the schedule for the next round of discussions.

3. The second round of the negotiations

It is important to maintain both momentum and continuity in treatynegotiations. Thus, the time lag between rounds should be minimized and,where possible, the composition of the delegations should be retained.

Before resuming the article-by-article or issue-by-issue review of thedraft, there should be a brief discussion of changes, if any, in the tax lawsof either country between the first and the second rounds.

The review of the draft should continue, further narrowing any dif-ferences which remained at the beginning of the second round. Thoughit is generally best not to reverse prior decisions, this should not be ruledout if either side considers it necessary. All decisions at this stage aremade subject to policy review.

On occasion agreements are reached in the course of negotiationswhich do not readily lend themselves to inclusion in the treaty, but whichnevertheless should be made public. There may, for example, be anagreed interpretation of a treaty provision, which is too detailed to gointo the treaty text. This interpretation may be spelt out in an exchangeof letters which could be signed at the same time as the treaty. Suchletters of understanding would not normally be subject to ratification, butwould form part of the public record.

If full agreement has been reached by the conclusion of the secondround, the complete treaty should be retyped and initialled by the headsof delegations. Initialling indicates that the draft reflects the agreementreached at the negotiating level.

If full agreement has not been reached, but nonetheless seems pos-sible, the procedures suggested in the subsections F.2 and F.3 may berepeated. Though it may be possible, at this stage, to conclude an agree-ment by correspondence, there may be value in scheduling a third, per-haps briefer, meeting so as not to lose momentum. It is much easier tounderstand each other's point of view in face-to-face discussions.

G. PREPARATIONS FOR THE SIGNATURE OF THE TREATY

Once agreement has been reached at the delegation level, the draftshould be reviewed by senior policy officials. At this stage, to an evengreater extent than during the negotiations, frivolous or minor changesshould be avoided, but if a strong policy reason for proposing a. changein the initialled draft is perceived, this information should be communi-cated immediately to the other delegation.

Once the draft is fully agreed, arrangements should be made forsignature at the earliest opportunity under the appropriate procedures ineach country. The need to conform texts in two languages can make thisa time-consuming process. This is normally handled by foreign ministries.

H. MISCELLANEOUS CONSIDERATIONS

Countries may find it useful to issue press releases or other publicstatements that negotiations are about to begin with a particular country.

159

The purpose of such a statement would be to solicit comments from in-terested parties. This procedure may serve two purposes. It may bring tolight issues that tax officials had not previously been aware of. Secondly,those in the private sector appreciate the opportunity to participate inthe treaty process.

The proceedings of the negotiations are normally treated as confi-dential until the treaty is signed. This has at least two positive purposes.It avoids locking negotiators into what may have been intended as tenta-tive negotiating positions. It also avoids subjecting negotiators to pres-sures from parties who would be affected by these tentative decisions.

Countries may wish to consider a procedure for reviewing the pro-gress of negotiations, during their course, with interested parties in theprivate sector. This would most profitably be done after the general pat-tern of the new treaty has been established but before final decisions aremade. It would serve to apprise the negotiators of some issues whichmay have surfaced after the beginning of the negotiations, or of problemswhich could result from provisions already tentatively agreed to. In suchmeetings, however, caution must be exercised not to reveal negotiatingpositions and other confidential information.

It is useful for the negotiators to maintain contact with economicofficers in their embassy in the capital of the other country and to keepthem advised of the progress of, discussions. Among other things, thisfacilitates the role of these officers in exchanging messages and othercommunications between formal negotiations sessions. These officers willoften sit in on those negotiations held in the country to which they areassigned.

Finally, experience has shown that social contacts between delega-tions during the negotiations are often most helpful in maintaining a highlevel of goodwill between the delegations. The value of such social con-tacts is in no way correlated with their elaborateness or cost.

160

Annex

MODEL CONVENTIONS AND DRAFT MODEL CONVENTIONSFOR THE AVOIDANCE OF DOUBLE TAXATION

PageI. Model Bilateral Convention for the Prevention of the Double Taxation

of Income (Mexico Draft) .................................... 161

II. Model Bilateral Convention for the Prevention of the Double Taxationof Income and Property (London Draft) ........................ 164

Ill. Model Convention for the Avoidance of Double Taxation BetweenMember Countries and Other Countries Outside the Andean Subregion(Andean Model) ............................................. 168

IV. Model Double Taxation Convention on Income and on Capital (OECD) 173

V. Convention on Administrative Assistance in Tax Matters concluded byDenmark, Finland, Iceland, Norway and Sweden .................. 184

I. MODEL BILATERAL CONVENTION FOR THE PREVENTION OF THEDOUBLE TAXATION OF INCOME

(MEXICO DRAFT)

Article I

1. The present Convention is designed to prevent double taxation in the caseof the taxpayers of the contracting States, whether nationals or not, as regards thefollowing taxes:

A. With reference to State A:1...... ..................................................2........................................................3. ...... ...............................................

B. With reference to State B:I. ........................................................2. ......................................................3. ........ ............................................

2. It is mutually agreed that the present Convention shall apply also to anyother tax, or increase of tax, imposed by either contracting State subsequent to thedate of signature of this Convention upon substantially the same bases as the taxesenumerated in the preceding paragraph of this Article.

Article II

Income from real property shall be- taxable only in the State in which theproperty is situated.

161

Article III

1. Income from mortgages on real property shall be taxable only in theState where the property is situated.

2. Income from mortgages on sea and/or air vessels shall be taxable only inthe State where such vessels are registered.

Article IV

1. Income from any industrial, commercial or agricultural business andfrom any other gainful activity shall be taxable only in the State where the businessor activity is carried out.

2. If an enterprise or an individual in one of the contracting States extendsits or his activities to the other State, through isolated or occasional transactions,without possessing in that State a permanent establishment, the income derivedfrom such activities shall be taxable only in the first State.

3. If an enterprise has a permanent establishment in each of the ContractingStates, each State shall tax that part of the income which is produced in its territory.

4. As regards agricultural and mining raw materials and other natural ma-terials and products, the income which results from prices prevailing between in-dependent persons or conforming to world market quotations shall be regarded asrealised in the State in which such materials or products have been produced.

Article V

Income which an enterprise of one of the contracting States derives from theoperation of ships or aircraft registered in such State is taxable only in that State.

Article VI

1. Directors' percentages, attendance fees and other special remunerationpaid to directors, managers and auditors of companies are taxable only in the Statewhere the fiscal domicile of the enterprise is situated.

2. If, however, such remuneration is paid for services rendered in a perma-nent establishment situated in the other contracting State, it shall be taxable only inthat State.

Article VII

1. Compensation for labour or personal services shall be taxable only in thecontracting State in which such services are rendered.

2. A person having his fiscal domicile in one contracting State shall, how-ever, be exempt from taxation in the other contracting State in respect of suchcompensation if he is temporarily present within the latter State for a period orperiods not exceeding a total of one hundred and eighty-three days during thecalendar year, and shall remain taxable in the first State.

3. If the person remains in the second State more than one hundred andeighty-three days, he shall be taxable therein in respect of compensation he earnedduring his stay there, but shall not be taxable in respect of such compensation inthe first State.

4. Income .derived by an accountant, an architect, a doctor, an engineer, alawyer or other person engaged in the practice of a liberal profession shall be tax-able only in the contracting State in which the person has a permanent establish-,ment at, or from, which he renders services.

5. If any such person has a permanent establishment in both contractingStates, he shall be taxable in each State only on the income received for servicesrendered therein.

162

Article VIII

1. Salaries, wages and other remuneration paid by bne of the contractingStates, or by public bodies, institutions or services depending on it, to its nationalscarrying out public functions in the other State shall be taxable only in the firstState, provided that these functions are included within the normal field of ac-tivity of the State, as this field is defined by international usage.

2. Public pensions shall be taxable only in the State of the debtor entity.

Article IX

Income from movable capital shall be taxable only in the contracting Statewhere such capital is invested.

Article X

1. Royalties from immovable property or in respect of the operation of amine, a quarry, or other natural resource shall be taxable only in the contractingState in which such property, mine, quarry, or other natural resoarce is situated.

2. Royalties and amounts received as a consideration for the right to use apatent, a secret process or formula, a trade-mark or other analogous right shall betaxable only in the State where such right is exploited.

3. Royalties derived from one of the contracting States by an individual,corporation or other entity of the other contracting State, in consideration for theright to use a musical, artistic, literary, scientific or other cultural work or publica-tion shall not be taxable in the former State.

Article XI

Private pensions and life annuities shall be taxable only in the State where thedebtor has his fiscal domicile.

Article XI

Gains derived from the sale or exchange of real property shall be taxable onlyin the State in which the property is situated.

Article XIII

The State where the taxpayer has his fiscal domicile shall retain the right totax the entire income of the taxpayer whether derived from its territory or fromthat of the other contracting State, but shall deduct from its tax on such entireincome the lesser of the two following amounts:

A. The tax collected by the latter contracting State on the income which istaxable in its territory according to the preceding Articles;

B. The amount which represents the same proportion in comparison with thetotal tax on the income that is taxable in both States as the income tax-able in the other State in comparison with the total income.

Article XIV

In the case of a taxpayer with a fiscal domicile in both contracting States, thetax, the collection of which under this Convention depends on fiscal domicile, shallbe imposed in each of the contracting States in proportion to the period of stayduring the preceding year or according to a proportion to be agreed by the com-

petent administrations.

Article XV

A taxpayer having his fiscal domicile in one of the contracting States shall not

163

be subject in the other contracting State, in respect of income he derives from thatState, to higher or other taxes than the taxes applicable in respect of the same in-come to a taxpayer having his fiscal domicile in the latter State, or having thenationality of that State.

Article XVI

1. When a taxpayer shows proof that the action of the tax administration ofone of the contracting States has resulted in double taxation, he shall be entitled tolodge a claim with the tax administration of the State in which he has his fiscaldomicile or of which he is a national.

2. Should the claim be admitted, the competent tax administration of thatState shall consult directly with the competent authority of the other State, with aview to reaching an agreement for an equitable avoidance of double taxation.

Article XVII

As regards any special provisions which may be necessary for the applicationof the present Convention, more particularly in cases not expressly provided for,the competent authorities of the two contracting States may confer together andtake the measures required in accordance with the spirit of this Convention.

Article XVIII

1. This Convention and the accompanying Protocol, which shall be con-sidered t6 be an integral part of the Convention, shall be ratified and the instru-ments of ratification shall be exchanged at ................ as soon as possible.

2. This Convention and Protocol shall become effective on the first day ofJanuary 19... They shall continue effective for a period of three years from thatdate and indefinitely after that period. They may, however, be terminated by eitherof the contracting States at the end of the three-year period or at any time there-after, provided that at least six months prior notice of termination has been given,the termination to become effective on the first day of January following the ex-piration of the six-month period.

DONE in duplicate, at this .... .... day of ......... 19..

H. MODEL BILATERAL CONVENTION FOR THE PREVENTIONOF THE DOUBLE TAXATION OF INCOME AND PROPERTY

(LONDON DRAFT)

Article I

1. The present Convention is designed to prevent double taxation in thecase of the taxpayers of the contracting States, whether nationals or not, as regardsthe following taxes:

A. With reference to State A:1........................................................2.......................................................3. ......................................................

B. With reference to State B:1. .......................................................2. ......................................................3. ......... ............................................

164

2. It is mutually agreed that the present Convention shall apply also to anyother tax, or increase of tax, imposed by either contracting State subsequent to thedate of signature of this Convention upon substantially the same bases as the taxesenumerated in the preceding paragraph of this Article.

Article II

Income from real property shall be taxable in the State in which the propertyis situated.

Article III

1. Income from mortgages on real property shall be taxable in the Statewhere the property is situated.

2. Income from mortgages on sea and/or air vessels shall be taxable in theState where such vessels are registered.

Article IV

1. Income derived from any industrial, commercial or agricultural enter-prise and from any other gainful occupation shall be taxable in the State where thetaxpayer has a permanent establishment.

2. If an enterprise in one State extends its activities to the other State with-out possessing a permanent establishment therein, the income derived from suchactivities shall be taxable only in the first State.

3. If any enterprise has a permanent establishment in each of the contractingStates, each State shall tax only that part of the income which is produced in itsterritory.

Article V

Income which an enterprise in one of the contracting States derives from theoperation of ships or aircraft engaged in international transport is taxable only inthe State in which the enterprise has its fiscal domicile.

Article VI

1. Remuneration for labour or personal services shall be taxable in the con-tracting State in which such services are rendered.

2. A person having his fiscal domicile in one contracting State shall, how-ever, be exempt from taxation in the other contracting State in respect of suchremuneration if he is temporarily present within the latter State for a period orperiods not exceeding a total of one hundred and eighty-three days during the tax-able year, and shall remain taxable in the first State.

3. If a person remains in the second State more than one hundred and eighty-three days, he shall be taxable therein in respect of the remuneration he earnedduring his stay there, but shall not be taxable in respect of such remuneration inthe first State.

4. Income derived by an accountant, an architect, an engineer, a lawyer, aphysician or other person engaged on his own account in the practice of a pro-fession shall be taxable in the contracting State in which the person has a perma-nent establishment at, or from, which he renders services.

5. If any person described in the preceding paragraph has a permanent es-tablishment in both contracting States, he shall be taxable in each State only onthe income for services rendered therein.

Article VII

Salaries, wages, pensions and other remuneration paid by the Government,

165

political subdivisions and governmental agencies of one of the contracting States tonationals of such State in respect of the performance of diplomatic, consular orother governmental functions in the other State, shall be taxable only in the firstState, provided that these functions are included within .the normal field of gov-ernmental functions and are not connected with the carrying on of a trade or busi-ness on behalf of the State, its subdivisions and its agencies.

Article VIII

1. Dividends and other income from shares in a company and shares ofprofits accruing to limited liability partners in a limited liability partnership shallbe taxable only in the contracting State where the company or limited liabilitypartnership has its fiscal domicile.

2. Notwithstanding the provisions of paragraph 1, dividends paid by a com-pany which has its fiscal domicile in one contracting State to a company which hasits fiscal domicile in the other contracting State and has a dominant participationin the management or capital of the company paying the dividends shall be exemptfrom tax in the former State.

3. Dividends paid by, or undistributed profits of, a company which has itsfiscal domicile in one contracting State shall not be subjected to any tax by theother contracting State by reason of the fact that the dividends or undistributedprofits represent, in whole or in part, income derived from the territory of thatother State.

Article IX

1. Interest on bonds, securities, notes, debentures or on any other form ofindebtedness shall be taxable only in the State where the creditor has his fiscaldomicile.

2. The State of the debtor is, however, entitled to tax such interest by meansof deduction or withholding at source.

3. The tax withheld at source under paragraph 2 of this Article shall in nocase exceed ....... per cent of the taxed interest.

Article X

1. Royalties from immovable property or in respect of the operation of amine, a quarry' or other natural resource shall be taxable only in the contractingState in which such property, mine, quarry or other natural resource is situated.

2. Royalties derived from one of the contracting States by an individual,corporation or other entity of the other contracting State in consideration for theright to use a patent, a secret process or formula, a trade-mark or other analogousright, shall not be taxable in the former State.

3. If, however, royalties are paid by an enterprise of one contracting State toanother enterprise of the other contracting State which has a dominant participa-tion in its management or capital, or vice versa, or when both enterprises are ownedor controlled by the same interests, the royalties shall be subject to taxation in theState where the right in consideration of which they are paid is exploited, subjectto deduction frqm the gross amount of such royalties of all expenses and charges,including depreciation, relative to such rights and royalties.

4. Royalties derived from one of the contracting States by an individual,corporation or other entity of the other contracting State, in consideration for theright to use an artistic, scientific or other cultural work or publication shall not betaxable in the former State.

Article XI

Private pensions and life annuities shall be taxable only in the State where therecipient has his fiscal domicile.

166

Article XII

1. Gains derived from the sale or exchange of real property shall be taxableonly in the country in which the property is situated.

2. Gains derived from the sale or exchange of assets other than real prop-erty, appertaining to an industrial, commercial or agricultural enterprise or to anyother independent occupation, shall be taxable according to the provisions ofArticles IV and V.

3. Gains derived from the sale or exchange of any capital assets other thanthose mentioned in the preceding paragraphs of the present Article shall be taxableonly in the State where the recipient has his fiscal domicile.

Article XIII

The State where the taxpayer has his fiscal domicile shall retain the right to taxthe entire income of the taxpayer whether derived from its territory or from that ofthe other contracting State, but shall deduct from its tax on such entire income thelesser of the following amounts:

A. The tax collected by the other contracting State on the income which istaxable in its territory according to the preceding Articles;

B. The amount which represents the same proportion of the tax of the Stateof fiscal domicile on the entire net income of the taxpayer as the net in-come taxable in the other State bears to the entire net income.

Article XIV

In the case of a taxpayer with a fiscal domicile in both contracting States, thetax, the collection of which under this Convention depends on fiscal domicile, shallbe imposed in each of the contracting States in proportion to the period of stayduring the taxable year or according to a proportion to be agreed by the competentadministrations.

Article XV

The provisions of the preceding Articles shall be applicable, mutatis mutandis,to taxes on property, capital or increment of wealth whether such taxes are per-manent or are levied once only.

Article XVI

A taxpayer having his fiscal domicile in one of the contracting States shall notbe subject in the other contracting State, in respect of income he derives from thatState, to higher or other taxes than the taxes applicable in respect of the sameincome to a taxpayer having his fiscal domicile in the latter State, or having thenationality of that State.

Article XVII

1. When a taxpayer shows proof that the action of the tax administrationof one of the contracting States has resulted in double taxation, he shall be entitledto lodge a claim with the tax administration of the State in which he has his fiscaldomicile or of which he is a national.

2. Should the claim be admitted, the competent tax administration of thatState shall consult directly with the competent authority of the other State, with aview to reaching an agreement for an equitable avoidance of double taxation.

Article XVIII

The provisions of the present Convention shall not be construed to restrict inany manner any exemption, deduction, credit, allowance, advantage and right ofadministrative or judicial appeal accorded to a taxpayer by the laws of either of thecontracting States.

167

Article XIX

As regards any special provisions which may be necessary for the applicationof the present Convention, more particularly in cases not expressly provided for,and in the event of substantial changes in the tax laws of either of the contractingStates, the competent authorities of the two contracting States shall confer togetherand take the measures required in accordance with the spirit of the presentConvention.

Article XX

1. This Convention and the accompanying Protocol, which shall be con-sidered to be an integral part of the Convention, shall be ratified and the instru-ments of ratification shall be exchanged at ............... as soon as possible.

2. This Convention and Protocol shall become effective on the first day ofJanuary 19. .. They shall continue effective for a period of three years from thatdate and indefinitely after that period. They may, however, be terminated by eitherof the contracting States at the end of the three-year period or at any time there-after, provided that at least six months prior notice of termination has been given,the termination to become effective on the first day of January following the ex-piration of the six-month period.

DONE in duplicate, at ......... this ...... day of ....... 19.....

III. MODEL CONVENTION FOR THE AVOIDANCE OF DOUBLE TAXA-TION BETWEEN MEMBER COUNTRIES AND OTHER COUNTRIESOUTSIDE THE ANDEAN SUBREGION

(ANDEAN MODEL)

CHAPTER I. SCOPE OF THE CONVENTION AND GENERAL DEFINITIONS

Article 1st: Scope of the Convention

The taxes subject to this Convention are:In the case of (State A):.........................................In the case of (State B): .........................................This Convention shall also apply to any future amendments of the above-

mentioned taxes, and to any taxes established by each Contracting State after thesigning of this Convention, which, by virtue of its tax base or its taxable matter, aresubstantially and economically similar to any of the above-cited taxes.

Article 2nd: General Definitions

For the purposes of this Convention, and unless otherwise defined:(a) The terms "one of the Contracting States" and "the other Contracting

State" mean (State A) or (State B), as the context requires.(b) The expressions "territory of one of the Contracting States" and "territory

of the other Contracting State" mean the territory of (State A) or the territory of(State B), as the context requires.

(c) The word "person" means:1. An individual2. A juridical person.

(d) An individual shall be deemed to be a resident of the Contracting Statein which said individual has his or her habitual abode.

168

A business enterprise shall be deemed to be a resident of the State specifiedin its articles of constitution. In the absence of articles of constitution, or if noState of residence is specified therein, the business enterprise shall be deemed to bea resident of the State wherein its actual managerial control is established.

Where the determination of the State of residence under these rules is notpossible, the competent authorities of the Contracting States shall decide the issueby mutual agreement.

(e) The word "source" means the activity, right, or property, that generates,or may generate, the income.

(f) The term "business activities" means activities undertaken by businessenterprises.

(g) The word "enterprise" means an organization constituted by one or morepersons, that undertakes a profit making activity.

(h) The terms "enterprise of a Contracting State" and "enterprise of the otherContracting State" mean an enterprise that is a resident of one of the ContractingStates.

(i) The word "royalty" means any benefit, thing of value, or sum of money,paid for the use, or for the privilege of using, copyrights, patents, industrial draw-ings or models, exclusive processes or formulas, trade marks, or other intangibleproperty of a similar nature.

(j) The term "capital gains" means the profit obtained by a person in thealienation of property not habitually acquired, produced, or transferred, in hisordinary line of business activity.

(k) The word "pension" means a periodic payment made in consideration ofservices rendered or injuries sustained; and the word "annuity" means a certainsum of money payable periodically during the life of the beneficiary, or during acertain period of time, gratuitously, or in consideration of payments made or ap-preciable in money.

(1) The term "competent authority" means, in the case of (State A), the.......... ... and in the case of (State B), the...............

Article 3rd: Meaning of Undefined Terms

Any word or term not defined in this Convention shall have the meaningassigned thereto by the legislation in force of each Contracting State.

CHAPTER 11. TAX ON INCOME

Article 4th: Tax Jurisdiction

Irrespective of the nationality or State of residence of a person, income ofwhatever nature received by such person shall be taxable only by the ContractingState wherein the source of such income is situated, except for the cases specifiedin this Convention.

Article 5th: Income from Real Property

Income of whatever kind from real property shall be taxable only by the Con-tracting State wherein such real property is situated.

Article 6th: Income from Rights to Exploit Natural Resources

Any benefit received from leasing or subleasing, or from transferring or grant-ing, any right to exploit or use in any manner whatsoever the natural resources ofone of the Contracting States, shall be taxable only by such Contracting State.

169

Article 7th: Business Profits

Profits resulting from business activities shall be taxable only by the Contract-ing State wherein such business activities have been undertaken.

It is understood that a business enterprise carries out activities in the territoryof a Contracting State, when it has in such Contracting State, any of, but notlimited to, the following:

(a) An office, or place of business management;(b) A factory, plant, industrial workshop, or assembly shop;(c) A construction project in progress;(d) A place or facility wherein natural resources are extracted or exploited,

such as a mine, well, quarry, plantation, or fishing boat;(e) An agency, or premises, for the sale of goods;(f) An agency, or premises, for the purchase of goods;(g) A depository, storage facility, warehouse, or any similar establishment

used for receiving, storing or delivering goods;(h) Any other premises, office, or facilities, the purpose of which, is prepara-

tory or auxiliary to the business activities of the enterprise;(i) An agent or representative.Where a business enterprise undertakes activities in both Contracting States,

each one of them may tax income from sources within its territory. If the activitiesare undertaken through representatives, or through the use of facilities, such as theones indicated in the preceding paragraph, the profits earned shall be attributed tosuch persons or facilities, provided that said persons or facilities are totally in-dependent from the business enterprise.

Article 8th: Profits of Transportation Enterprises

The profits earned by a transportation enterprise from its air, land, sea, lakeor river operations, shall be liable to taxation only by the Contracting State ofwhich such enterprise is a resident.

Article 8th: Alternative

The profits earned by a transportation enterprise from its air, land, sea, lakeor river operations in any of the Contracting States, shall be taxable only by suchContracting State.

Article 9th: Royalties from the Use of Patents,Trade Marks and Technology

Royalties derived from the use of patents, trade marks, nonpatented technicalknowledge, or other similar intangible property, within the territory of one of theContracting States, shall be taxable only by such Contracting State.

Article 10th: Interest

Interest derived from loans shall be taxable only by the Contracting State inthe territory of which the loan has been used.

Subject to rebuttal, it is presumed that the loan has been used in the ContractingState from which the interest payment has been made.

Article 11th: Dividends and Shares of Profit

Dividends and shares of profit shall be taxable only by the Contracting Stateof which the business enterprise paying them is a resident.

170

Article 12th: Capital Gains

Capital gains shall be taxable only by the Contracting State wherein the prop-erty is situated at the time of the sale, except for capital gains derived from thealienation of:

(a) Ships, aircraft, buses, and other transportation vehicles, which shall betaxable only by the Contracting State wherein such vehicles are registered at thetime of the alienation thereof, and

(b) Negotiable instruments, shares of stock and other securities, which shallbe taxable only by the Contracting State in which territory they have been issued.

Article 13th: Income from the Rendering of Personal Services

Remunerations, fees, wages, salaries, benefits, and similar compensation, re-ceived as payments for services rendered by employees, professionals or techni-cians, or for personal services in general, shall be taxable only in the territorywherein such services have been rendered, except for wages, salaries, remunera-tions, and similar compensation, received by:

(a) Persons rendering services to a Contracting State in the discharge ofofficial duties duly accredited, which shall be taxable only by such ContractingState, even if the services have been rendered within the territory of the otherContracting State.

(b) The crews of ships, aircraft, buses and other transportation vehicles en-gaged in international traffic, which shall be taxable only by the Contracting Stateof which the employer is a resident.

Article 14th: Professional Service and Technical AssistanceBusiness Enterprises

Income received by business enterprises engaged in rendering professionalservices or technical assistance, shall be taxable only by the Contracting Statewherein such services or assistance are rendered.

Article 15th: Pensions and Annuities

Pensions, annuities, and other periodic income of a similar character, shall betaxable only by the Contracting State wherein the source of such income is situated.

The source is considered to be situated in the territory of the State where thecontract providing for such periodic income is executed, and, if there is no contract,in the State from which the payment of such income is made.

Article 16th: Public Entertainment Activities

Income derived from artistic or public entertainment activities shall be taxableonly by the Contracting State wherein such activities have been carried out, with-out regard to the time that the persons performing said activities stay in the territoryof such Contracting State.

CHAPTER III. TAXES ON-MTWEALTH

Article 17th: Taxes on Net Wealth

Net wealth situated within the territory of one of the Contracting States shallbe taxable only by such Contracting State.

Article 18th: Status of Transportation Vehicles, Loans, and Securities

For the purposes of the preceding Article, it is understood that:

171

(a) Aircraft, ships, buses, and other transportation vehicles, as well as thepersonal property used in the operation thereof, are situated in the ContractingState wherein their respective ownership is registered.

(b) Loans, shares of stock, and other securities, are situated in the Con-tracting State of which the debtor, or the issuing enterprise, is a resident.

CHAPTER IV. GENERAL PROVISIONS

Article 19th: Consultations and Information

The competent authorities of the Contracting States shall hold consultationsbetween themselves and exchange the information necessary for deciding by mutualagreement any difficulty or doubt which may arise out of the application of thisConvention, and for establishing the administrative controls required for theavoidance of fraud and tax evasion.

The information exchanged pursuant to the provisions of the preceding para-graph shall be considered as confidential, and shall not be transmitted to any personother than the authorities responsible for the administration of the taxes which aresubject to this Convention.

For the purposes of this Article, the competent authorities of the ContractingStates may communicate directly between themselves.

Article 20th: Ratification

This Convention shall be ratified by the governments of the Contracting Statesin accordance with their respective constitutional and legal requirements.

The instruments of ratification shall be exchanged at ................ assoon as possible.

Upon the exchange of the instruments of ratification, this Convention shallhave effect and apply:

(a) With respect to income of individuals, to income received on and afterthe first day of January of the calendar year following the year of the ratification.

(b) With respect to business profits, to profits received during the first fiscalyear starting after the ratification of this Convention.

(c) With respect to other taxes, to those in which the assessment thereofcorresponds to the calendar year following the year of the ratification.

Article 21st: Effectiveness and Termination

This Convention shall remain in force and effect indefinitely, but either of theContracting States, from the first day of January to the 30th day of June of anycalendar year, may denounce the Convention by giving notice thereof in writingto the other Contracting States, and, in such event, the Convention shall cease tohave effect:

(a) With respect to income of individuals, as of the first day of January ofthe calendar year immediately following the year in which such notice is given.

(b) With respect to income of juridical persons after the closing of the fiscalyear the beginning of which would have occurred during the calendar year inwhich notice of termination of this Convention is given.

(c) With respect to the other taxes, as of the first day of January of thecalendar year following the year in which such notice is given.

IN TESTIMONY WHEREOF, the respective plenipotentiaries have hereunto settheir hands and seals.

172

M ADE at .......... ..... on the ........ day of ........ in ........copies ........ in the ........ language, and ........ copies in the ........language, with the ............... .copies being equally valid and authentic.

IV. MODEL DOUBLE TAXATION CONVENTION ONINCOME AND ON CAPITAL

(OECD)

SCOPE OF THE CONVENTION

Article 1. Personal scope

This Convention shall apply to persons who are residents of one or both ofthe Contracting States.

Article 2. Taxes covered

1. This Convention shall apply to taxes on income and on capital imposedon behalf of a Contracting State or of its political subdivisions or local authorities,irrespective of the manner in which they are levied.

2. There shall be regarded as taxes on income and on capital all taxes im-posed on total income, on total capital, or on elements of income or of capital,including taxes on gains from the alienation of movable or immovable property,taxes on the total amounts of wages or salaries paid by enterprises, as well as taxeson capital appreciation.

3. The existing taxes to which the Convention shall apply are in particular:(a) (in State A):..............................................(b) (in State B):..............................................4. The Convention shall apply also to any identical or substantially similar

taxes which are imposed after the date of signature of the Convention in additionto, or in place of, the existing taxes. At the end of each year, the competent authori-ties of the Contracting States shall notify each other of changes which have beenmade in their respective taxation laws.

DEFINITIONS

Article 3. General definitions

1. For the purposes of this Convention, unless the context otherwise requires:

(a) the term "person" includes an individual, a company and any other bodyof persons;

(b) the term "company" means any body corporate or any entity whichis treated as a body corporate for tax purposes;

(c) the terms "enterprise of a Contracting State" and "enterprise of the otherCoAtracting State" means respectively an enterprise carried on by a resident of aContracting State and an enterprise carried on by a resident of the other Con-tracting State;

(d) the term "international traffic" means any transport by a ship or aircraftoperated by an enterprise which has its place of effective management in a Con-tracting State, except when the ship or aircraft is operated solely between placesin the other Contracting State;

(e) the term "competent authority" means:

173

(i) (in State A):..............................................(ii) (in State B):..............................................2. As regards the application of the Convention by a Contracting State any

term not defined therein shall, unless the context otherwise requires, have themeaning which it has under the law of that State concerning the taxes to whichthe Convention applies.

Article 4. Resident

1. For the purposes of this Convention, the term "resident of a ContractingState" means any person who, under the laws of that State, is liable to tax thereinby reason of his domicile, residence, place of management or any other criterionof a similar nature. But this term does not include any person who is liable to taxin that State in respect only of income from sources in that State or capital situatedtherein.

2. Where by reason of the provisions of paragraph 1 an individual is a resi-dent of both Contracting States, then his status shall be determined as follows:

(a) he shall be deemed to be a resident of the State in which he has a per-manent home available to him; if he has a permanent home available to him inboth States, he shall be deemed to be a resident of the State with which his personaland economic relations are closer (centre of vital interest);

(b) if the State in which he has his centre of vital interests cannot be deter-mined, or if he has not a permanent home available to him in either State, he shallbe deemed to be a resident of the State in which he has an habitual abode;

(c) if he has an habitual abode in both States or in neither of them, he shallbe deemed to be a resident of the State of which he is a national;

(d) if he is a national of both States or of neither of them, the competentauthorities of the Contracting States shall settle the question by mutual agreement.

3. Where by reason of the provisions of paragraph 1 a person other than anindividual is a resident of both Contracting States, then it shall be deemed to be aresident of the State in which its place of effective management is situated.

Article 5. Permanent establishment

1. For the purposes of this Convention, the term "permanent establishment"means a fixed place of business through which the business of an enterprise iswholly or partly carried on.

2. The term "permanent establishment" includes especially:(a) a place of management;(b) a branch;(c) an office;(d) a factory;(e) a workshop, and(f) a mine, an oil or gas well, a quarry or any other place of extraction of

natural resources.3. A building site or construction or installation project constitutes a "per-

manent establishment only if it lasts more than 12 months.4. Notwithstanding the preceding provisions of this Article, the term "per-

manent establishment" shall be deemed not to include:(a) the use of facilities solely for the purpose of storage, display or delivery

of goods or merchandise belonging to the enterprise;(b) the maintenance of a stock of goods or merchandise belonging to the

enterprise solely for the purpose of storage, display or delivery;(c) the maintenance of a stock of goods or merchandise belonging to the

enterprise solely for the purpose of processing by another enterprise;

174

(d) the maintenance of a fixed place of business solely for the purpose ofpurchasing goods or merchandise or of collecting information, for the enterprise;

(e) the maintenance of a fixed place of business solely for the purpose ofcarrying on, for the enterprise, any other activity of a preparatory or auxiliarycharacter;

(f) the maintenance of a fixed place of business solely for any combinationof activities mentioned in subparagraphs (a) to (e), provided that the overall activityof the fixed place of business resulting from this combination is of a preparatoryor auxiliary character.

5. Notwithstanding the provisions of paragraphs 1 and 2, where a person-other than an agent of an independent status to whom paragraph 6 applies-isacting on behalf of an enterprise and has, and habitually exercises, in a Contract-ing State an authority to conclude contracts in the name of the enterprise, thatenterprise shall be deemed to have a permanent establishment in that State inrespect of any activities which that person undertakes for the enterprise, unlessthe activities of such person are limited to those mentioned in paragraph 4 which,if exercised through a fixed place of business, would not make this fixed place ofbusiness a permanent establishment under the provisions of that paragraph.

6. An enterprise shall not be deemed to have a permanent establishment ina Contracting State merely because it carries on business in that State through abroker, general commission agent or any other agent of an independent status,provided that such persons are acting in the ordinary course of their business.

7. The fact that a company which is a resident of a Contracting State con-trols or is controlled by a company which is a resident of the other ContractingState, or which carries on business in that other State (whether through a per-manent establishment or otherwise), shall not of itself constitute either companya permanent establishment of the other.

TAXATION OF INCOME

Article 6. Income from immovable property

1. Income derived by a resident of a Contracting State from immovableproperty (including income from agriculture or forestry) situated in the other Con-tracting State may be taxed in that other State.

2. The term "immovable property" shall have the meaning which it hasunder the law of the Contracting State in which the property in question is situated.The term shall in any case include property accessory to immovable property,livestock and equipment used in agriculture and forestry, rights to which the pro-visions of general law respecting landed property apply, usufruct of immovableproperty and rights to variable or fixed payments as consideration for the workingof, or the right to work, mineral deposits, sources and other natural resources;ships, boats and aircraft shall not be regarded as immovable property.

3. The provisions of paragraph 1 shall apply to income derived from thedirect use, letting, or use in any other form of immovable property.

4. The provisions of paragraphs 1 and 3 shall also apply to the income fromimmovable property of an enterprise and to income from immovable propertyused for the performance of independent personal services.

Article 7. Business profits

1. The profits of an enterprise of a Contracting State shall be taxable onlyin that State unless the enterprise carries on business in the other Contracting Statethrough a permanent establishment situated therein. If the enterprise carries onbusiness as aforesaid, the profits of the enterprise may be taxed in the other Statebut only so much of them as is attributable to that permanent establishment.

175

2. Subject to the provisions of paragraph 3, where an enterprise of a Con-tracting State carries on business in the other Contracting State through a per-manent establishment situated therein, there shall in each Contracting State beattributed to that permanent establishment the profits which it might be expectedto make if it were a distinct and separate enterprise engaged in the same or similaractivities under the same or similar conditions and dealing wholly independentlywith the enterprise of which it is a permanent establishment.

3. In determining the profits of a permanent establishment, there shall beallowed as deductions expenses which are incurred for the purposes of the per-manent establishment, including executive and general administrative expenses soincurred, whether in the State in which the permanent establishment is situatedor elsewhere.

4. In so far as it has been customary in a Contracting State to determinethe profits to be attributed to a permanent establishment on the basis of an appor-tionment of the total profits of the enterprise to its various parts, nothing inparagraph 2 shall preclude that Contracting State from determining the profits tobe taxed by such an apportionment as may be customary; the method of appor-tionment adopted shall, however, be such that the result shall be in accordance withthe principles contained in this Article.

5. No profits shall be attributed to a permanent establishment by reason ofthe mere purchase by that permanent establishment of goods or merchandise forthe enterprise.

6. For the purposes of the preceding paragraphs, the profits to be attributedto the permanent establishment shall be determined by the same method year byyear unless there is good and sufficient reason to the contrary.

7. Where profits include items of income which are dealt with separately inother Articles of this Convention, then the provisions of those Articles shall notbe affected by the provisions of this Article.

Article 8. Shipping, inland waterways transport and air transport

1. Profits from the operation of ships or aircraft in international traffic shallbe taxable only in the Contracting State in which the place of effective managementof the enterprise is situated.

2. Profits from the operation of boats engaged in inland waterways transportshall be taxable only in the Contracting State in which the place of effective man-agement of the enterprise is situated.

3. If the place of effective management of a shipping enterprise or of aninland waterways transport enterprise is aboard a ship or boat, then it shall bedeemed to be situated in the Contracting State in which the home harbour of theship or boat is situated, or, if there is no such home harbour, in the ContractingState of which the operator of the ship or boat is a resident.

4. The provisions of paragraph 1 shall also apply to profits from the partici-pation in a pool, a joint business or an international operating agency.

Article 9. Associated enterprises

1. Where(a) an enterprise of a Contracting State participates directly or indirectly,

in the management, control or capital of an enterprise of the other ContractingState, or

(b) the same persons participate directly or indirectly in the management,control or capital of an enterprise of a Contracting State and an enterprise of theother Contracting State,

176

and in either case conditions are made or imposed between the two enterprises intheir commercial or financial relations which differ from those which would bemade between independent enterprises, then any profits which would, but for thoseconditions, have accrued to one of the enterprises, but, by reason of those con-ditions, have not so accrued, may be included in the profits of that enterprise andtaxed accordingly.

2. Where a Contracting State includes in the profits of an enterprise of thatState-and taxes accordingly-profits on which an enterprise of the other Con-tracting State has been charged to tax in that other State and the profits so includedare profits which would have accrued to the enterprise of the first-mentioned Stateif the conditions made between the two enterprises had been those which wouldhave been made between independent enterprises, then that other State shall makean appropriate adjustment to the amount of the tax charged therein on those profits.In determining such adjustment, due regard shall be had to the other provisions ofthis Convention and the competent authorities of the Contracting States shall if nec-essary consult each other.

Article 10. Dividends

1. Dividends paid by a company which is a resident of a Contracting Stateto a resident of the other Contracting State may be taxed in that other State.

2. However, such dividends may also be taxed in the Contracting State ofwhich the company paying the dividends is a resident and according to the laws ofthat State, but if the recipient is the beneficial owner of the dividends the tax socharged shall not exceed:

(a) 5 per cent of the gross amount of the dividends if the beneficial owneris a company (other than a partnership) which holds directly at least 25 per centof the capital of the company paying the dividends;

(b) 15 per cent of the gross amount of the dividends in all other cases.The competent authorities of the Contracting States shall by mutual agreementsettle the mode of application of these limitations.

This paragraph shall not affect the taxation of the company in respect of theprofits out of which the dividends are paid.

3. The term "dividends" as used in this Article means income from shares,"jouissance" share or "jouissance" rights, mining shares, founders' shares or otherrights, not being debt-claims, participating in profits, as well as income from othercorporate rights which is subjected to the same taxation treatment as income fromshares by the laws of the State of which the company making the distribution isa resident.

4. The provisions of paragraphs I and 2 shall not apply if the beneficialowner of the dividends, being a resident of a Contracting State, carries on businessin the other Contracting State of which the company paying the dividends is aresident, through a permanent establishment situated therein, or performs in thatother State independent personal services from a fixed base situated therein, andthe holding in respect of which the dividends are paid is effectively connected withsuch permanent establishment or fixed base. In such case the provisions of Article 7or Article 14, as the case may be, shall apply.

5. Where a company which is a resident of a Contracting State derivesprofits or income from the other Contracting State, that other State may notimpose any tax on the dividends paid by the company, except in so far as suchdividends are paid to a resident of that other State or in so far as the holding inrespect of which the dividends are paid is effectively connected with a permanentestablishment or a fixed base situated in that other State, nor subject the company'sundistributed profits to a tax on the company's undistributed profits, even if thedividends paid or the undistributed profits consist wholly or partly of profits orincome arising in such other State.

177

Article 11. Interest

1. Interest arising in a Contracting State and paid to a resident of the otherContracting State may be taxed in that other State.

2. However, such interest may also be taxed in the Contracting State inwhich it arises and according to the laws of that State, but if the recipient is thebeneficial owner of the interest the tax so charged shall not exceed 10 per cent ofthe gross amount of the interest. The competent authorities of the Contracting Stateshall by mutual agreement settle the mode of application of this limitation.

3. The term "interest" as used in this Article means income from debt-claimsof every kind, whether or not secured by mortgage and whether or not carryinga right to participate in the debtor's profits, and in particular, income from govern-ment securities and income from bonds or debentures, including premiums andprizes attaching to such securities, bonds or debentures. Penalty charges for latepayments shall not be regarded as interest for the purpose of this Article.

4. The provisions of paragraphs 1 and 2 shall not apply if the beneficialowner of the interest, being a resident of a Contracting State, carries on businessin the other Contracting State in which the interest arises, through a permanentestablishment situated therein, or performs in that other State independent personalservices from a fixed base situated therein, and the debt-claim in respect of whichthe interest is paid is effectively connected with such permanent establishment orfixed base. In such case the provisions of Article 7 or Article 14, as the case maybe, shall apply.

5. Interest shall be deemed to arise in a Contracting State when the payer isthat State itself, a political subdivision, a local authority or a resident of that State.Where, however, the person paying the interest, whether he is a resident of a Con-tracting State or not, has in a Contracting State a permanent establishment or afixed base in connection with which the indebtedness on which the interest is paidwas incurred, and such interest is borne by such permanent establishment or fixedbase, then such interest shall be deenied to arise in the State in which the per-manent establishment or fixed base is situated.

6. Where, by reason of a special relationship between the payer and thebeneficial owner or between both of them and some other person, the amount ofthe interest, having regard to the debt-claim for which it is paid, exceeds theamount which would have been agreed upon by the payer and the beneficialowner in the absence of such relationship, the provisions of this Article shall applyonly to the last-mentioned amount. In such case, the excess part of the paymentsshall remain taxable according to the laws of each Contracting State, due regardbeing had to the other provisions of this Convention.

Article 12. Royalties

1. Royalties arising in a Contracting State and paid to a resident of the otherContracting State shall be taxable only in that other State if such resident is thebeneficial owner of the royalties.

2. The term "royalties" as used in this Article means payments of any kindreceived as a consideration for the use of, or the right to use, any copyright ofliterary, artistic or scientific work including cinematograph films, any patent, trademark, design or model, plan, secret formula or process, or for the use of, or theright to use, industrial, commercial, or scientific equipment, or for informationconcerning industrial, commercial or scientific experience.

3. The provisions of paragraph 1 shall not apply if the beneficial owner ofthe royalties, being a resident of a Contracting State, carries on business in theother Contracting State in which the royalties arise, through a permanent estab-lishment situated therein, or performs in that other State independent personalservices from a fixed base situated therein, and the right or property in respectof which the royalties are paid is effectively connected with such permanent estab-

178

lishment or fixed base. In such case the provisions of Article 7 or Article 14, as thecase may be, shall apply.

4. Where, by reason of a special relationship between the payer and thebeneficial owner or between both of them and some other person, the amount ofthe royalties, having regard to the use, right or information for which they arepaid, exceeds the amount which would have been agreed upon by the payer andthe beneficial owner in the absence of such relationship, the provisions of thisArticle shall apply only to the last-mentioned amount. In such case, the excesspart of the payments shall remain taxable according to the laws of each Con-tracting State, due regard being had to the other provisions of this Convention.

Article 13. Capital gains1. Gains derived by a resident of a Contracting State from the alienation

of immovable property referred to in Article 6 and situated in the other Contract-ing State may be taxed in that other State.

2. Gains from the alienation of movable property forming part of thebusiness property of a permanent establishment which an enterprise of a Con-tracting State has in the other Contracting State or of movable property pertainingto a fixed base available to a resident of a Contracting State in the other Con-tracting State for the purpose of performing independent personal services, in-cluding such gains from the alienation of such a permanent establishment (aloneor with the whole enterprise) or of such fixed base, may be taxed in that other State.

3. Gains from the alienation of ships or aircraft operated in internationaltraffic, boats engaged in inland waterways transport or movable property pertain-ing to the operation of such ships, aircraft or boats, shall be taxable only in theContracting State in which the place of effective management of the enterpriseis situated.

4. Gains from the alienation of any property other than that referred toin paragraphs 1, 2 and 3, shall be taxable only in the Contracting State of whichthe alienator is a resident.

Article 14. Independent personal services

1. Income derived by a resident of a Contracting State in respect of profes-sional services or other activities of an independent character shall be taxable onlyin that State unless he has a fixed base regularly available to him in the otherContracting State for the purpose of performing his activities. If he has such afixed base, the income may be taxed in the other State but only so much of itas is attributable to that fixed base.

2. The term "professional services" includes especially independent scientific,literary, artistic, educational or teaching activities as well as the independent activi-ties of physicians, lawyers, engineers, architects, dentists and accountants.

Article 15. Dependent personal services

1. Subject to the provisions of Articles 16, 18 and 19, salaries, wages andother similar remuneration derived by a resident of a Contracting State in respectof an employment- shall be taxable only in that State unless the employment isexercised in the other Contracting State. If the employment is so exercised, suchremuneration as is derived therefrom may be taxed in that other State.

2. Notwithstanding the provisions of paragraph 1, remuneration derived bya resident of a Contracting State in respect of an employment exercised in theother Contracting State shall be taxable only in the first-mentioned State if:

(a) the recipient is present in the other State for a period or periods not ex-ceeding in the aggregate 183 days in the fiscal year concerned, and

(b) the remuneration is paid by, or on behalf of, an employer who is not aresident of the other State, and

179

(c) the remuneration is not borne by a permanent establishment or a fixedbase which the employer has in the other State.

3. Notwithstanding the preceding provisions of this Article, remunerationderived in respect of an employment exercised aboard a ship or aircraft operatedin international traffic, or aboard a boat engaged in inland waterways transport, maybe taxed in the Contracting State in which the place of effective management ofthe enterprise is situated.

Article 16. Directors' fees

Directors' fees and other similar payments derived by a resident of a Con-tracting State in his capacity as a member of the board of directors of a companywhich is a resident of the other Contracting State may be taxed in that other State.

Article 17. Artistes and athletes

1. Notwithstanding the provisions of Articles 14 and 15, income derived bya resident of a Contracting State as an entertainer, such as a theatre, motion pic-ture, radio or television artiste, or a musician, or as an athlete, from his personalactivities as such exercised in the other Contracting State, may be taxed in thatother State.

2. Where income in respect of personal activities exercised by an entertaineror an athlete in his capacity as such accrues not to the entertainer or athlete himselfbut to another person, that income may, notwithstanding the provisions of Articles7, 14 and 15, be taxed in the Contracting State in which the alctivities of theertettainer r' athlete are exercised.

Article 18. Pensions

Subject to the provisions of paragraph 2 of Article 19, pensions and othersimilar remuneration paid to a resident of a Contracting State in consideration ofpast employment shall be taxable only in that State.

Article 19. Government service

1. (a) Remuneration, other than a pension, paid by a Contracting Stateor a political subdivision or a local authority thereof to an individual in respectof services rendered to that State or subdivision or authority shall be taxable onlyin that State.

(b) However, such remuneration shall be taxable only in the other Contract-ing State if the services are rendered in that State and the individual is a residentof that State who:

(i) is a national of that State; or

(ii) did not become a resident of that State solely for the purpose of render-ing the services.

2. (a) Any pension paid by, or out of funds created by, a Contracting Stateor a political subdivision or a local authority thereof to an individual in respectof services rendered to that State or subdivision or authority shall be taxable onlyin that State.

(b) However, such pension shall be taxable only in the other ContractingState if the individual is a resident of, and a national of, that State.

3. The provisions of Articles 15, 16 and 18 shall apply to remuneration andpensions in respect of services rendered in connection with a business carried onby a Contracting State or a political subdivision or a local authority thereof.

Article 20. Students

Payments which a student or business apprentice who is or was immediatelybefore visiting a Contracting State a resident of the other Contracting State and

180

who is present in the first-mentioned State solely for the purpose of his educationor training receives for the purpose of his maintenance, education or training shallnot be taxed in that State, provided that such payments arise from sources outsidethat State.

Article 21. Other income

1. Items of income of a resident of a Contracting State, wherever arising,not dealt with in the foregoing Articles of this Convention shall be taxable onlyin that State.

2. The provisions of paragraph 1 shall not apply to income, other thanincome from immovable property as defined in paragraph 2 of Article 6, if therecipient of such income, being a resident of a Contracting State, carries on businessin the other Contracting State through a permanent establishment situated therein,or performs in that other State independent personal services from a fixed basesituated therein, and the right or property in respect of which the income is paidis effectively connected with such permanent establishment or fixed base. In suchcase the provisions of Article 7 or Article 14, as the case may be, shall apply.

Article 22. Taxation of capital

1. Capital represented by immovable property referred to in Article 6, ownedby a resident of a Contracting State and situated in the other Contracting State,may be taxed in that other State.

2. Capital represented by movable property forming part of the businessproperty of a permanent establishment which an enterprise of a Contracting Statehas in the other Contracting State or by movable property pertaining to a fixedbase available to a resident of a Contracting State in the other Contracting State forthe purpose of performing independent personal services, may be taxed in thatother State.

3. Capital represented by ships and aircraft operated in international trafficand by boats engaged in inland waterways transport, and by movable propertypertaining to the operation of such ships, aircraft and boats, shall be taxable onlyin the Contracting State in which the place of effective management of the enter-prise is situated.

4. All other elements of capital of a resident of a Contracting State shallbe taxable only in that State.

Article 23A. Methods for elimination of double taxation

Exemption method

1. Where a resident of a Contracting State derives income or owns capitalwhich, in accordance with the provisions of this Convention, may be taxed in theother Contracting State, the first-mentioned State shall, subject to the provisions ofparagraphs 2 and 3, exempt such income or capital from tax.

2. Where a resident of a Contracting State derives items of income which,in accordance with the provisions of Articles 10 and 11, may be taxed in the otherContracting State, the first-mentioned State shall allow as a deduction from thetax on the income of that resident an amount equal to the tax paid in that otherState. Such deduction shall not, however, exceed that part of the tax, as computedbefore the deduction is given, which is attributable to such items of income derivedfrom that other State.

3. Where in accordance with any provision of the Convention income de-rived or capital owned by a resident of a Contracting State is exempt from tax inthat State, such State may nevertheless, in calculating the amount of tax on theremaining income or capital of such resident, take into account the exempted in-come or capital.

181

Article 23B. Credit method

1. Where a resident of a Contracting State derives income or owns capitalwhich, in accordance with the provisions of this Convention, may be taxed in theother Contracting State, the first-mentioned State shall allow:

(a) as a deduction from the tax on the income of that resident, an amountequal to the income tax paid in that other State;

(b) as a deduction from the tax on the capital of that resident, an amountequal to the capital tax paid in that other State.

Such deduction in either case shall not, however, exceed that part of the incometax or capital tax, as computed before the deduction is given which is attributable,as the case may be, to the income or the capital which may be taxed in that otherState.

2. Where in accordance with any provision of the Convention income de-rived or capital owned by a resident of a Contracting State is exempt from taxin that State, such State may nevertheless, in calculating the amount of tax onthe remaining income or capital of such resident, take into account the exemptedincome or capital.

Article 24. Non-discrimination

1. Nationals of a Contracting State shall not be subjected in the otherContracting State to any taxation or any requirement connected therewith, whichis other or more burdensome than the taxation and connected requirements towhich nationals of that other State in the same circumstances are or may be sub-jected. This provision shall, notwithstanding the provisions of Article 1, also applyto persons who are not residents of one or both of the Contracting States.

2. The term "nationals" means:

(a) all individuals possessing the nationality of a Contracting State;

(b) all legal persons, partnerships and associations deriving their status assuch from the laws in force in a Contracting State.

3. Stateless persons who are residents of a Contracting State shall not besubjected in either Contracting State to any taxation or any requirement connectedtherewith, which is other or more burdensome than the taxation and connectedrequirements to which nationals of the State concerned in the same circumstancesare or may be subjected.

4. The taxation on a permanent establishment which an enterprise of a Con-tracting State has in the other Contracting State shall not be less favourably leviedin that other State than the taxation levied on enterprises of that other State carry-ing on the same activities. This provision shall not be construed as obliging aContracting State to grant to residents of the other Contracting State any personalallowances, reliefs and reductions for taxation purposes on account of civil statusor family responsibilities which it grants to its own residents.

5. Except where the provisions of paragraph 1 of Article 9, paragraph 6 ofArticle 11, or paragraph 4 of Article 12, apply, interest, royalties and other dis-bursements paid by an enterprise of a Contracting State to a resident of the otherContracting State shall, for the purpose of determining the taxable profits of suchenterprise, be deductible under the same conditions as if they had been paid to aresident of the first-mentioned State. Similarly, any debts of an enterprise of aContracting State to a resident of the other Contracting State shall, for the purposeof determining the taxable capital of such enterprise, be deductible under the sameconditions as if they had been contracted to a resident of the first-mentioned State.

6. Enterprise of a Contracting State, the capital of which is wholly or partlyowned or controlled, directly or indirectly, by one or more residents of the other

182

Contracting State, shall not be subjected in the first-mentioned State to any taxationor any requirement connected therewith which is other or more burdensome thanthe taxation and connected requirements to which other similar enterprises of thefirst-mentioned State are or may be subjected.

7. The provisions of this Article shall, notwithstanding the provisions ofArticle 2, apply to taxes of every kind and description.

Article 25. Mutual agreement procedure

1. Where a person considers that the actions of one or both of the Con-tracting States result or will result for him in taxation not in accordance with theprovisions of this Convention, he may, irrespective of the remedies provided bythe domestic law of those States, present his case to the competent authority of theContracting State of which he is a resident or, if his case comes under paragraph1 of Article 24, to that of the Contracting State of which he is a national. The casemust be presented within three years from the first notification of the action result-ing in taxation not in accordance with the provisions of the Convention.

2. The competent authority shall endeavour, if the objection appears to itto be justified and if it is not itself able to arrive at a satisfactory solution, to re-solve the case by mutual agreement with the competent authority of the otherContracting State, with a view to the avoidance of taxation which is not in ac-cordance with the Convention. Any agreement reached shall be implemented not-withstanding any time limits in the domestic law of the Contracting States.

3. The competent authorities of the Contracting States shall endeavour toresolve by mutual agreement any difficulties or doubts arising as to the interpre-tation or application of the Convention. They may also consult together for theelimination of double taxation in cases not provided for in the Convention.

4. The competent authorities of the Contracting States may communicatewith each other directly for the purpose of reaching an agreement in the sense ofthe preceding paragraphs. When it seems advisable in order to reach agreement tohave an oral exchange of opinions, such exchange may take place through a Com-mission consisting of representatives of the competent authorities of the ContractingStates.

Article 26. Exchange of information

1. The competent authorities of the Contracting States shall exchange suchinformation as is necessary for carrying out the provisions of this Convention or ofthe domestic laws of the Contracting States concerning taxes covered by the Con-vention insofar as the taxation thereunder is not contrary to the Convention. Theexchange of information is not restricted by Article 1. Any information received bya Contracting State shall be treated as secret in the same manner as informationobtained under the domestic laws of that State and shall be disclosed only to per-sons or authorities (including courts and administrative bodies) involved in theassessment or collection of, the enforcement or prosecution in respect of, or thedetermination of appeals in relation to, the taxes covered by the Convention. Such

.persons or authorities shall use the information only for such purposes. They maydisclose the information in public court proceedings or in judicial decisions.

2. In no case shall the provisions of paragraph 1 be construed so as to im-pbse on a Contracting State the obligation:

(a) to carry out administrative measures at variance with the laws and ad-ministrative practice of that or of the other Contracting State;

(b) to supply information which is not obtainable under the laws or in thenormal course of the administration of that or of the other Contracting State;

(c) to supply information which would disclose any trade, business, indus-trial, commercial or professional secret or trade process, or information, the dis-closure of which would be contrary to public policy (ordre public).

183

Article 27. Diplomatic agents and consular officers

Nothing in this Convention shall affect the fiscal privileges of diplomatic agentsor consular officers under the general rules of international law or under theprovisions of special agreements.

Article 28. Territorial extension

1. This Convention may be extended, either in its entirety or with any neces-sary modification [to any part of the territory of (State A) or of (State B) which isspecifically excluded from the application of the Convention or], to any State orterritory for whose international relations (State A) or (State B) is responsible,which imposes taxes substantially similar in character to those to which the Con-vention applies. Any such extension shall take effect from such date and subject tosuch modifications and conditions, including conditions as to termination, as maybe specified and agreed between the Contracting States in notes to be exchangedthrough diplomatic channels or in any other manner in accordance with their con-stitutional procedures.

2. Unless otherwise agreed by both Contracting States, the termination ofthe Convention by one of them under Article 30 shall also terminate, in the mannerprovided for in that Article, the application of the Convention [to any part of theterritory of (State A) or of (State B) or] to any State or territory to which it hasbeen extended under this Article. '

Article 29. Entry into force

1. This Convention shall be ratified and the instruments of ratification shallbe exchanged at ............ as soon as possible.

2. The Convention shall enter into force upon the exchange of instrumentsof ratification and its provisions shall have effect:

(a) (in State A): .....................

(b) (in State B):..............................................

Article 30. Termination

This Convention shall remain in force until terminated by a Contracting State.Either Contracting State may terminate the Convention, through diplomatic chan-nels, by giving notice of termination at least six months before the end of anycalendar year after the year ......... In such event, the Convention shall cease tohave effect:

(a) (in State A):..............................................(b) (in State B):..............................................

Terminal clause

[Note:The terminal clause concerning the signing shall be drafted in accordance with

the constitutional procedure of both Contracting States.]

V. CONVENTION ON ADMINISTRATIVE ASSISTANCE IN TAX MATTERSCONCLUDED BY DENMARK, FINLAND, ICELAND, NORWAY ANDSWEDEN

The Governments of Denmark, Finland, Iceland, Norway and Sweden, desir-ing to conclude a Convention on administrative assistance in tax matters, haveagreed as follows:

184

GENERAL PROVISIONS

Article 1

The Contracting States undertake to assist each other in tax matters in themanner specified below.

Assistance according to this Convention may comprise:(a) service of documents,(b) information on tax matters, such as procurement of tax returns or other

documents and exchange of information without special request or upon requestin a particular case,

(c) provision of tax return forms and other tax forms, and(d) collection and enforcement of tax claims.

Article 2

For the purposes of this Convention the term "tax" shall include:(a) tax, covered by a Convention between the Contracting States for the

avoidance of double taxation with respect to taxes on income, capital, inheritanceor estates,

(b) gift tax,(c) motor-vehicle tax, to the extent indicated in an agreement according to

Article 20,(d) value added tax and other general turnover tax, to the extent indicated

in an agreement according to Article 20,(e) social security contributions and other public levies, to the extent indi-

cated in an agreement according to Article 20.Advance payments of any taxes and levies referred to in the first paragraph of

this Article-shall be regarded as tax.

Article 3a

A Contracting State is obliged to lend assistance in accordance with Article 1with regard to all tax matters and in all tax claims which have arisen in anotherContracting State in accordance with the legislation of that State concerning thetaxes and levies covered by Article 2. However, in matters concerning tax men-tioned in Article 2 (a), such obligation shall exist only if the tax is covered by aconvention for the avoidance of double taxation with the Contracting State request-ing the assistance.

Assistance may include measures not only against a taxpayer but also againstan employer and any other person who have been under an obligation to withholdtax on wages and other remuneration, and against other persons, who are liable forthe tax according to the legislation of the State requesting assistance.

Requests for assistance shall not be made unless the requesting State in accord-ance with its own legislation would be able to provide corresponding assistance atthe request of the requested State.

Article 4

Requests for assistance and correspondence between the Contracting Statesaccording to this Convention shall be undertaken by the Competent Authoritiesof the said States.

The term "Competent Authority" means, in the case of Denmark: the Ministryof Finance, the Tax Department, in the Case of Finland: the Ministry of Finance

- Article 3 was given this amended wording by a supplementary agreement of21 July 1976.

185

and the National Board of Taxes, in the Case of Iceland: the Ministry of Finance,in the case of Norway: the Ministry of Finance and Customs and in the case ofSweden: the Ministry of Finance, or such authority in each of the ContractingStates which has been authorised to deal with matters which relate to thisConvention.

Article 5

Requests and other documents relating to assistance shall be written in theDanish, Norwegian or Swedish language or be accompanied by a translation intoone of those languages. In cases of service of documents, however, this shall applyonly to the request for service.

The request for assistance shall contain the name of the authority which origi-nally has asked for the assistance as well as the name, profession or title, address,date of birth, place of domicile and, if possible, place of employment and abodeof the person concerned. The request ought furthermore to contain any additionalinformation which might serve in identifying this person.

Article 6

A request for assistance may be refused if the requested State regards suchassistance as being contrary to its public interests.

Article 7

If a request for assistance is declined, the requesting State shall be notifiedimmediately of the decision and the reasons therefor.

If assistance is effected, the requested State shall without delay notify theother State of the outcome of the assistance.

Any notification given under this Article shall also contain any informationwhich may be relevant for further measures in the tax matter.

Article 8

Documents issued or certified by a court or an administrative authority of oneof the Contracting States need not be legalised prior to use in tax matters within theterritory of another Contracting State. The same applies to documents signed by acourt official or an official of an authority, if such signature is sufficient accordingto the law of the State in which the court or authority is established.

SERVICE OF DOCUMENTS,

Article 9

Service of documents in accordance with this Convention shall be effected inthe same way as is required by the law or administrative practice of the requestedState for similar service of documents. Requests for service shall include a briefnote of the contents of the document.

If the requesting State so wishes, the service may be carried out under aspecial procedure, in so far as the procedure requested is in accordance with thelegislation of the State in which the service is to be effected.

Article 10

A dated and attested acknowledgement by the person-upon whom the docu-ment has been served or a certificate, showing the form and the date of service,issued by the proper authority of the requested State, shall be accepted as proof ofservice.

186

PROCUREMENT OF INFORMATION

Article 11b

Information shall be procured in accordance with the legislation of the re-quested State.

Requests for procurement of information may be refused where a business,manufacturing or professional secret would be disclosed if the request were com-plied with.

Article 11 AcRepresentatives of the authority of a Contracting State may, if a tax matter

is of substantial interest to that State, at the request of the Competent Authority ofthat State be allowed to be present at an investigation of such a tax matter inanother Contracting State. The request is to be considered by the Competent Au-thority of that other State, who shall notify the Competent Authority of the first-mentioned State of its decision as soon as possible. If the request is approved, theCompetent Authority making the request shall be informed about the time andplace of the investigation and about other particulars considered necessary for therequesting authority.

Representatives referred to in the first paragraph shall not make decisions onmatters relating to the investigation but shall forward proposals in such matters tothe authority or the official in charge of the investigation. Decisions on such pro-posals are to be taken by the authority or the official in charge.

Information revealed at the investigation is to be treated as secret and shallnot be disclosed to persons or authorities, including courts and other judicial au-thorities, other than those concerned with the assessment or collection of, theenforcement or prosecution in respect of, or the determination of appeals in rela-tion to, the taxes which are the subject of this Convention.

If the request referred to in the first paragraph is refused, the provisions ofthe first paragraph of Article 7 shall apply.

Article 12d

The Competent Authority of a Contracting State shall, in so far as it is possibleon the basis of available statements of income or similar information, send to theCompetent Authorities in each of the other Contracting States, as soon as possibleafter the end of each calendar year and without being specially requested to do so,information concerning individuals and legal persons resident in that State,regarding

(a) dividends by joint stock companies and similar legal persons,(b) interest on bonds and similar securities,(c) balances with banks, savings banks and similar institutions and interest

on such balances,(d) royalties and other charges paid periodically for the utilisation of copy-

rights, patents, designs, trade marks or other such rights or property,(e) wages, salaries, fees, pensions and annuities,

(f) damages, insurance payments and other similar compensation obtained inconnection with trade or business activities and

(g) other income or property, to the extent set out in an agreement accord-ing to Article 20.

b Article 11 was given this amended wording by a supplementary agreementof 21 July 1976.

e Article 11 A was added by the supplementary agreement of 21 July, 1976.d Article 12 was given this amended wording by the supplementary agreement

of 21 July 1976.

187

The Competent Authority of a Contracting State shall seek to ensure thatinformation which is revealed at investigations of a tax matter in that State andwhich could be deemed to have a bearing on such matter in another ContractingState, is immediately transmitted to the Competent Authority of that other State.

If it appears to the receiving State that the information received does notcorrespond to the actual facts, the Competent Authority of that State shall com-municate these facts in a suitable way to the Competent Authority of the Statewhich has provided the information.

Where a resident of a Contracting State has died and has left immovableproperty in another Contracting State or assets invested in a trade or business inthat State, the Competent Authority of the first-mentioned State, shall, as soon asthe facts have come to their attention, inform the Competent Authority of theother State.

ENFORCEMENT OF TAX CLAIMS

Article 13

Any decision in tax matters which according to the legislation of a ContractingState is enforceable in that State shall be accepted for enforcement in anotherContracting State. Assistance for enforcement of a tax claim by virtue of suchdecision shall be given in the last-mentioned State according to the procedureprovided for in its law and under the statutes of limitation of that State with re-spect to the recovery of a tax of a similar type.

The authority which originally requests assistance in recovery shall certify inthe request that the decision is enforceable in the requesting State and indicate thedate on which the right to collect the tax expires, fully or partially, on account ofstatutes of limitation of that State. The competence of such authority shall be con-firmed by the authority refer'd to in Article 4.

Article 14

A request by a State for assistance in the enforcement of a tax claim may bemade only if the tax cannot be recovered in that State without considerabledifficulty.

Where a taxpayer or any other person referred to in the second paragraph ofArticle 3 has died, recovery may not be made of an amount exceeding the valueof the assets of the estate. If the estate has been distibuted, the amount recoverablefrom an heir or any other person who has acquired property because of the deathmay not exceed the value of the property at the time of acquisition.

Article 15

Tax which is to be recovered under this Convention shall not enjoy suchspecial priority right for tax which may exist in the requested State with respectto its own taxes.

In a case concerning recovery of tax under this Convention, measures forinitiating proceedings in the requested State at a court, other than an administrativecourt or at a bankruptcy proceedings may not be taken unless the Competent Au-thority of that State, on request by the Competent Authority of the requestingState, expressly consents to such a measure.

Article 16

Where according to the legislation of the requesting State the right to collecta tax, fully or partially, expires owing to payment, reduction or waiver of assess-

188

ment, remission or any other reason before the conclusion of the enforcementprocedures under this Convention, the Competent Authority of that State shall, assoon as possible, inform the Competent Authority of the other State of the factsoccurred.

The provisions of the first paragraph shall also apply where time for paymentof the tax has been allowed.

Article 17

When recovery under this Convention has been effected in one of the Statesand the amount recovered has reached the tax collection authority of that State,that State shall be responsible to the requesting State for the amount recovered.

SPECIAL PROVISIONS

Article 18

Inquiries, information, statements and other communications received by oneof the States under this Convention shall be covered by the provisions of secrecyapplicable under the legislation of that State.

Article 19

The requesting State shall be liable to pay costs for assistance under this Con-vention only if the costs are incurred in courts, other than administrative courts,or at bankruptcy proceedings in the other State.

Article 20

The Competent Authorities of the Contracting States may conclude furtheragreements for the implementation of the provisions of this Convention. They may,in particular, conclude agreements on the exchange of information according toArticle 12 (g), on the minimum amount for which a request for recovery may bemade, on assistance in respect of taxes and levies according to Article 2 (c), (d)and (e) and on collection of tax in certain cases, e.g., with respect to the so-calledfrontier workers, and on interests, court costs, penalties and other similar amountscharged in connection with taxation, enforcement or recovery regarding determina-tion of exchange rates of amounts to be recovered and regarding rendering of ac-counts for amounts recovered.

Where difficulties or doubts arise between two or more Contracting Statesregarding the interpretation or application of this Convention, the Competent Au-thorities of these States shall consult together with a view to solve the matter bymeans of a special agreement. The result of such consultations shall be communi-cated to the Competent Authorities of the other Contracting States as soon aspossible.

If the Competent Authority of a Contracting State is of the opinion that theCompetent Authorities of all Contracting States should consult together regardingthe interpretation or application of this Convention, then such consultations shalltake place on the request of that State.

Article 21

This Convention shall not apply on:In the case of Denmark; the Faroe Islands and Greenland;

In the case of Norway; Svalbard and Jan Mayen and the Norwegian possessionsoutside Europe.

189

Article 22

This Convention shall enter into force at the beginning of the calendar yearnext following the year in which all of the Contracting States have notified theSwedish Ministry for Foreign Affairs that the constitutional measures required forthe entry into force of the Convention have been effected.

The Swedish Ministry for Foreign Affairs shall inform the other ContractingStates of the receipt of these notifications.

Article 23

After the entry into force of this Convention the provisions contained thereinshall apply to matters received by the Competent Authority of the requested Stateafter the entry into force.

The Conventions stated below shall cease to be effective and shall be appliedfor the last time with regard to matters received by the Competent Authority of therequested State before the entry into force of this Convention:

Convention of 10th March, 1943, between Finland and Sweden on adminis-trative assistance in tax matters;

Convention of 17th December, 1949, between Norway and Sweden on adminis-trative assistance in tax matters;

Convention of 27th October, 1953, between Denmark and Sweden on adminis-trative assistance in tax matters;

Convention of 29th March, 1954, between Finland and Norway on adminis-trative assistance in tax matters;

Convention of 18th July, 1955, between Denmark and Finland on adminis-trative assistance in tax matters;

Convention of 23rd May, 1956, between Denmark and Norway on adminis-trative assistance in tax matters.

Article 24

The present Convention shall remain in force indefinitely but a ContractingState may, not later than six months before the end of a calendar year, give toeach of the other Contracting States through diplomatic channels notice of termi-nation. If the time of notice of termination has been observed the Convention willcease to be effective between the State which has given the notice and the otherContracting States at the end of the calendar year.

Requests for assistance received by the Competent Authority of the requestedState before the termination of the Convention shall be complied with in accord-ance with the provisions of the Convention.

The Convention shall be deposited with the Swedish Ministry for ForeignAffairs which shall forward certified copies to each of the Governments of theContracting States.

IN WITNESS WHEREOF the undersigned, being duly authorised thereto, havesigned the present Convention and have affixed thereto their seals.

DONE at Stockholm on 9th November, 1972, in the Danish, Finnish, Icelandic,Norwegian and Swedish languages, two texts being made in Swedish, one forSweden and one for Finland, all of which are equally authentic.

190

HOW TO OBTAIN UNITED NATIONS PUBLICATIONS

United Nations publications may be obtained from bookstores and distributorsthroughout the world. Consult your bookstore or write to: United Nations, SalesSection, New York or Geneva.

COMMENT SE PROCURER LES PUBLICATIONS DES NATIONS UNIES

Les publications des Nations Unies sont en vente dans les librairies et les agencesd~positaires du monde entier. Informez-vous auprs de votre libraire ou adressez-vousA : Nations Unies, Section des ventes, New York ou Genbve.

RAE IOJIYMHTh H3J(AHHH OrAHH3AIHH OB'bEJLHHEHHhlX HAIIHH

H3aaHHH OpraHHsarumi O6'begHHemanix Haimfn MO)XHO KYnHTh B KHH)KEBlX Mara-3HHax K areHTCTBax Ho Beex pafoHax MHpa. HaBoHTe CnpaBKH 06 H3gaHHHx BBaLmeM KHH)RHOM Mara3HHe HllH nIIHTe no agpecy: OpraHHuaInHa O6SIegHHeHHblXHanrgk, CeKlXn no upogame n3gaHH , Hbio-Hopxa Hmi )ReHea.

COMO CONSEGUIR PUBLICACIONES DE LAS NACIONES UNIDAS

Las publicaciones de las Naciones Unidas estin en venta en librerias y casas distri-buidoras en todas partes del mundo. Consulte a su librero o dirijase a: NacionesUnidas, Secei6n de Ventas, Nueva York o Ginebra.

Printed in U.S.A. Price: $U.S. 10.00 United Nations publication35530-August 1979-3,000 (or equivalent in Sales No. E.79.XVI.3

other currencies) ST/ESA/94