The OECD Model Convention - reflections and developments
Thank you for inviting me here to talk on the OECD Model Convention. I would like to take this opportunity not only to consider the history and context of recent developments, but also to look forward to the challenges that, I think, may lie ahead. I'd also like to give you an update on ongoing work in a number of related areas.
Work on Model Double Taxation Conventions began about 80 years ago under the auspices of the League of Nations, culminating in the preparation of two Models, one in Mexico during the second world war and another in London immediately afterwards.
The baton then passed to the Organisation for European Economic Co-operation in the late 1950s. Its successor body, the OECD, carried on this work and published its first Model in 1963.
Now that we are accustomed to updates of the OECD Model every couple of years or so, it is surprising to think that 14 years elapsed before the first update in 1977; and a further 15 years went by before the next one in 1992.
In 1992 the OECD decided to work continuously on the Model, with the result that changes have come relatively thick and fast. To a large extent this reflects the increased globalisation of the world economy and the ever-increasing international mobility of goods, capital and people. All these developments give rise to new problems and issues if double taxation is to be avoided. So the OECD Model and its Commentary have to be ever more responsive.
The most recent update was published at the end of January this year. As usual there are a lot changes to the Commentary. You may already be familiar with parts of this update, as some of the work was previously released in draft form.
A few highlights are:
A new Article on assistance in the collection of taxes - Article 27. Such articles are becoming increasingly widespread. The addition of a model article in the OECD Model provides a useful basis for negotiating such provisions and its commentary provides guidance on its application;
Clarification of the application of domestic anti-abuse rules under tax treaties. This is set out in Article 1 of the Commentary;
Commentary, also on Article 1, concerning the restriction of the entitlement to treaty benefits;
Clarification of the application of the permanent establishment definition in e-commerce. This work was carried out in response to business calls for clarification of these issues. The conclusions were approved by the Committee on Fiscal Affairs in December 2000 and made public in February 2001;
Extensive commentary was added on the application of Article 5, the permanent establishment definition. It covers a number of key questions relating to mobile services, in particular what constitutes a fixed place of business, the length of time required to satisfy the duration test and whether separate places may constitute a single place of business;
Changes to Article 12 (Royalties) resulting from the work on the Treaty Characterization of E-commerce Payments.
We are already hard at work on the next update, which should appear in a couple of years or so. Let me touch on some of the more significant issues currently under consideration.
Last year we issued a consultation paper on stock options and have been working on the comments received. An important - perhaps the key - issue was whether the gain arising from options granted through employment should be regarded as income from that employment rather than a capital gain on shares. The "income from employment" view has now been accepted as the correct one. We are now concentrating on how double taxation can best be prevented, and regulatory burdens eased, given that countries have differing domestic stock option schemes and taxation rules for their own, very good, reasons. The aim is to get a revised paper out into the public domain, with proposed additions to the Commentary, later this year.
We have also all but finalised a lengthy paper on the taxation of pensions and on the deductibility of contributions to pension schemes. It will clarify a number of technical issues relating to cross-border pension payments and set out a range of alternative provisions for the taxation of pensions under Article 18, including the rationale for the variations.
We have also been working closely with the international air transport and shipping operators on clarifying the application of Article 8 of the OECD Model, particularly in relation to the scope of the Article. It is a good example of the benefits that can be had from working with the industry experts on what can be technically complex issues.
We are also considering the issue of dispute resolution in general. This will involve seeing if the mutual agreement procedure can be made to work more efficiently and effectively. But we will also look at other means of dispute resolution, including arbitration in which we know that business has shown great interest. Personally, I have an open mind on the merits of arbitration as a dispute resolution mechanism. I do think it is a subject that deserves careful consideration and I welcome the contributions from the International Chamber of Commerce, IFA and others on this subject. As I think is clear, there are many issues that need to be considered. We should not fool ourselves that it is all very straightforward. We do need to think through how it would work: for example, who the arbitrators might be, whether all the consequences of their decisions would be followed through, constitutional issues and so on. I look forward to the ongoing debate on this issue.
Another piece of work that we will embark upon later this year concerns the treatment under tax treaties of trusts and investment funds. To some extent this will be a development of the work that was concluded a few years ago on partnerships. Similar issues arise concerning the attribution of income where entities are viewed as fiscally transparent in one country and as taxable entities in their own right in another.
If countries are to apply the Model correctly, they need to ascertain the necessary facts. Tax authorities want to ensure that all their taxpayers pay the right amount of tax due. Exchange of information between tax authorities is a crucial tool in helping them to achieve that.
The importance of effective exchange of information has increased in recent years. There is now international consensus that the way to root out cross-border tax evasion and avoidance is through international co-operation to promote transparency and exchange of information. Exchange of information is a key theme in both the OECD's harmful tax practices initiative and the EU draft Directive on Savings. And in its widest sense it is an important element in helping tackle organised financial crime and terrorism.
The most widely recognised standard for international exchange of information has been Article 26 of the Model Convention. Although the importance of exchange of information has increased in recent years, the text of Article 26 has not been reviewed to reflect the changing trend.
We have decided that, as a matter of priority, we should undertake a comprehensive review of Article 26 and its commentary to ensure they reflect international developments and that they continue to provide the best legal framework for carrying out exchange of information. The review should be completed by the end of this year, and will take into account the OECD Model Agreement on Exchange of Information on Tax Matters, which was published in April 2002 after being developed jointly by OECD and non-OECD countries. The joint development of that agreement is a good example of our desire to consult and work with other organisations and countries, a subject I will return to later.
The Model Agreement is written in much more precise terms than Article 26 and is now regarded as setting the international standard for effective exchange of information. My personal view is that the principles now embodied in the Model Agreement on Exchange of Information on Tax Matters should be incorporated in Article 26.
We are also looking at the progress made by member countries on implementing the OECD's Report on Improving Access to Bank Information for Tax Purposes published in 2000. Work on this goes hand in hand with the comprehensive review of Article 26. And to echo the recent statement by G7 Finance Ministers, I hope all OECD countries will work towards implementing the standards in the 2000 report.
I mentioned earlier that the recent update of the OECD Model Tax Convention has, as usual, included a number of changes to the Commentary. Changes to the Articles of the Model, however, are much less frequent.
There are many reasons for this. One is the fact that there are many hundreds of tax conventions in existence which need to be interpreted and applied as they stand to the new issues that arise, for example concerning electronic commerce and stock options. Some countries - the UK and France for example - have over 100 treaties each and it is simply impracticable to expect each of them to embark upon a renegotiation programme to bring them up to date with special new Articles dealing with these new issues.
So a way has to be found to interpret the conventions that are already in place. By explaining through the Commentaries how old wording can continue to be meaningful, the OECD enables treaties to continue to solve international tax problems, and not to become fossilised.
But sometimes I wonder if that is the right approach. There is a limit to the pressures that can be put on treaty wording that was developed decades ago in the face of situations that were not remotely in the minds of the people who developed it.
There is something odd about a situation in which most countries revisit and update their tax legislation every year while tax treaties have an average life of - who knows? - say, 12 to 15 years.
The UK and the US signalled in their new treaty the intention to revisit it whenever issues arise, and at the latest after 5 years. That sort of commitment is vital with such an important treaty. Doing it for all of them would be a massive undertaking.
So I think that governments have to adopt flexible and pragmatic solutions. A simple one may be to negotiate and bring into effect short protocols dealing with perhaps only one or two issues on which both countries are agreed. I think there is a lot to be said for the use of protocols to solve particular problems. We do not always need comprehensive treaty renegotiations. This is type of flexibility -and it is only one example - helps governments and businesses alike.
Some people say that a multilateral tax treaty would be another way of making progress. And certainly if it took no longer to negotiate a treaty with 10 countries than it did with one, there would be a clear benefit. The coverage of tax treaties would improve, as would standardisation of treatment of common situations in which double taxation might arise.
But there are formidable difficulties. First, there is the time factor. The more different countries are involved in the negotiation process, the longer it will take. It is as simple as that. And, perhaps more importantly, a multilateral convention risks becoming even more inflexible than a bilateral one. At the moment you only need two countries to agree on a renegotiation. Imagine what it would be like if 10 had to be brought to the starting line together. Imagine too the problem of reconciling a large number of tax systems and tax treaty policies.
One only has to look at the commentary on the OECD Model Tax Convention itself to see how far apart some countries tax treaty policies can be. This is especially true as regards the balance between taxation in the source country and taxation in the residence state. For example I know the UK was happy to negotiate zero source country taxation on dividends, interest and royalties with the United States. But many other countries - even among our European neighbours - may not want to reach the same agreement. A multilateral treaty might not produce as good an outcome for some countries as might be achieved bilaterally.
All these issues are, and will become, the subject of ever increasing debate. And that is why I am happy to raise them with you. The OECD is getting better at consulting with business. We know we can do more but we have started down the road. We are, for example, starting to release material earlier than we did before. Much of the recent OECD Model Tax Convention update was published on the OECD website in the Autumn of 2001. I have mentioned the consultation paper on stock options last year. And we have published papers and held a seminar on the work being done on the attribution of profits to permanent establishments. I will come back to this.
We have also set up TAGs - or Technical Advisory Groups - with members from OECD countries, non-OECD economies and business. They were formed to take forward the Committee's work on electronic commerce following the 1998 Ottawa Conference, and have looked at:
consumption tax issues,
the characterisation of payments and the taxation of business profits, and
compliance, information and documentation issues.
I certainly see the TAGs as a very useful addition to the way in which we consult the business community, while bringing on board non-member economies, and I believe that is a view shared widely across OECD's membership. Although there are issues we still need to address in the TAGs - for example, at present business representation tends to dominate - it is clear to me that they have made a valuable contribution to our work. We should build on that for the future.
Our work with non-OECD economies has been increasing in recent years. Our regular meeting in September with 40 or 50 non-OECD economies from around the world has become an important feature of the international tax calendar. The seminar forms part of the OECD's Global Forum on Taxation. It plays an important role in keeping non-OECD countries in touch with, and participating in, the work of the OECD. We seek to work closely with non-OECD economies. I envisage a future of ever-stronger links between the OECD and non-OECD world. It is no longer the case that a single organisation - even one with 30 members - can pretend that it knows all the answers, or can even fully appreciate all the questions.
The globalisation of the world economy poses many challenges to those, whether tax administrations, businesses or professional advisers, involved in taxing business profits on a national basis. Nowhere are the challenges more apparent than in the issue of transfer pricing. Businesses still know whether or not they are making profits. Well, most of them still know. And they know pretty well the relative contributions of their various functions in adding value. But many multinationals, especially those relying heavily on intangible assets, are finding it increasingly difficult to identify the geographic location in which functions are performed and in which profits arise.
The OECD responded to this challenge in 1995 by giving the world the updated Transfer Pricing Guidelines. This buttressed our reputation as the premier international standard setter for taxation. But the world of international business, and international business taxation, has changed enormously since 1995 and the rate of change is not slackening. The OECD must continue to rise to this challenge.
First, it means that we need to ensure that we have a really good understanding of what is currently going on. I am convinced that an essential element of this is to involve the business community effectively in all aspects of our work. We need to go beyond straightforward consultation and learn to develop the habit of sharing our concerns about issues and having real discussions about the merits of different options. An example of what I mean was a very stimulating roundtable discussion about issues around the debt/equity distinction we held recently.
Second, it means that we need to be prepared to think radically. A number of people have been questioning whether the arm's length principle underlying transfer pricing rules will continue to be sustainable. There is talk about formulary apportionment, an issue that has been going in and out of fashion for some decades now. I have not come here to signal the demise of the arm's length principle. Far from it. It has stood the test of time as both a principled and a practical way of addressing some very tricky issues. No other approach has any track record at all in an international arena. But I would say that we need to think deeply and objectively about what really is the best way to approach transfer pricing in the modern world.
Third, it means we need to think broadly. There are all sorts of big issues about, for example, transfer pricing, controlled foreign companies, non-discrimination, harmful tax practices. Each issue is complicated in its own right. But they all inter-connect with each other to produce a new dimension of complexity. We need to face up to this challenge. We must not be intimidated by the complexity and retreat into examining fine details because we have not learned how to confront the big picture.
The march of electronic commerce into all our lives has already been an erratic journey. In the last 5 years we have seen the internet bubble grow, burst, and then slowly re-inflate. The ways in which the technological revolution we are undergoing will impact on some basic principles of international taxation are not yet clear. But already we see the multiplicity of ways in which new business models emerge to exploit the technology. Centralisation of support functions, outsourcing, remote working and the use of the Internet as a medium for advertising, selling and even delivery of product direct to customers are already with us. All we can say for certain is that the process of change will continue, and we must be prepared to question time-honoured principles of taxation to ensure that they remain fit for the purpose.
The OECD is working to address these challenges through the Business Profits TAG, bringing together representatives from OECD member and non-member economies, business interests and academia. In looking at the pressures on the Model Tax Convention arising from new technologies, they are examining the very building blocks on which double taxation treaties are built: the concepts of company residence, the permanent establishment threshold, residence and source taxation, transfer pricing and the attribution of profits. If we are to make real progress in providing solutions that work in the modern world, it is clear that this dialogue must be encouraged and developed. OECD members can no longer work in a vacuum; we must bring business and non-member economies into the discussion and be prepared to take full account of what they say.
We will need to address the fear many non-member economies have that e-commerce will adversely impact on developing countries' tax revenues when business can be done in their country without a physical presence. We must strive to ensure that avoidance of double taxation can be combined with ensuring appropriate single taxation. And at the same time ensure that tax rules do not become barriers to international trade, either through increased regulatory requirements, or by the failure of national administrations to agree on how to allocate taxation rights.
We also need to ensure a consistent approach for the collection of consumption taxes on electronically supplied services, drawing on the Ottawa framework principles of neutrality, efficiency, certainty and simplicity, effectiveness and fairness, and flexibility. The OECD's Consumption Tax TAG is working to define the place of consumption and, as necessary, to simplify and modernise current consumption tax systems. This includes work to identify and examine technology based tax collection mechanisms for cross border business to consumer supplies. At their meeting this week, the TAG reached broad agreement on many of these issues. The intention is to publish a comprehensive report covering all aspects of our work on e-commerce this summer.
As some of you will know, the OECD has important work underway to achieve greater international consensus about the attribution of profits to permanent establishments, with a particular focus on the financial sector where branches are commonly used for business reasons. I thought you might like a report on progress.
In early 2001, two discussion drafts on the attribution of profits to permanent establishments were issued for comments. The first of these covered general considerations, while the second was focused on banks. A good number of responses were received, particularly from industry bodies and professional firms, and these were followed by a public consultation in Paris last year.
So where have we got to since then? I'm pleased to tell you that an extensively revised version of the document on banks was issued this week. The revisions focus on the key areas raised during the consultation, i.e. the booking of loans, attribution of capital (including "free" capital) and the recognition of internal dealings. The new version also includes an annex that responds directly to some of the points raised by business, and explains why they have not been included in the revised draft.
We have also released a discussion paper on a third topic, the global trading of financial instruments. That paper discusses both attribution of profit issues and transfer pricing issues, especially the use of profit methods to allocate the profit of a global trading book.
Once again, we shall - very much - welcome comments. And we have not forgotten the first discussion draft, on general issues, the revision of which - in the light of public consultation - is the next priority. Here, work is likely to focus on two main issues - intangible property and capital attribution /funding.
Although the permanent establishment concept has proven to be a remarkably resilient and adaptable threshold for over 100 years, it is not without problems, which the OECD is paying attention to. It's no surprise that the facts and circumstances of each and every business and its organisation will be unique, and that has implications for the permanent establishment concept. We in the OECD rely on Article 5 to award taxing rights with some certainty and with relatively little head scratching. And it's fair to say that in the vast majority of cases, excluding perhaps cases where the facts are not clear-cut, that certainty is available with reference to Article 5 and the Commentary.
Some member countries link the model treaty Article 5 to their own domestic legislation. So for them, a clear understanding is doubly important.
The first phase of the OECD's current work on the permanent establishment definition has been to provide greater certainty through further guidance on the application of the existing rules, particularly in respect of problems areas such as short term and mobile service activities. This resulted in significant additions to the Commentary on Article 5 in the recent update of the OECD Model. The next phase of the work will examine whether Article 5 itself requires modification to meet the challenges resulting from business and technological change.
I should say that at the moment I don't think we need to abandon completely the permanent establishment concept. As I noted earlier it is a remarkably resilient and adaptable threshold and it is an integral part of all existing double tax conventions. The focus of possible reform will primarily be on problem areas such as high value, short term and mobile services. These are activities which the traditional permanent establishment threshold, based on a bricks and mortar establishment, does not cope very well with.
What are the options for change? Different rules have been included in bilateral conventions over the years which provide us with insights as to their suitability. Rules that deem certain mobile services to constitute a permanent establishment after a certain duration have a greater chance of gaining acceptance than a withholding tax on gross service payments which can lead to excessive taxation. I don't think we can afford to do nothing. It would be better for the OECD to develop some fair and sensible rules than leave it to bilateral negations to develop solutions.
Italy is one of the countries that has no independent legislation on permanent establishment and relies on the concept of PE contained in the Convention. And I can understand business concerns at the Italian Supreme Court's recommendations in the Italian case that has been the talk of some tax circles.
We should however remember that each case that tax practitioners and tax authorities consider needs to be decided by reference to its own unique facts. We need to be careful not to conclude that the Commentary needs amendment each time a particular set of facts leads to a conclusion that some may not be comfortable with.
We considered recently some draft amendments to the Commentary on Article 5 proposed by a number of private sector parties following the Italian case. I should stress that we are not considering the case itself but the issues arising out of it that have generated comment, with a view to considering the need for any amendment to the Commentary. And I think that we must be careful about how we change the Commentary, if we decide to do so.
Some people think it is clear enough already, and that there is little point in clarifying it further as any court, anywhere in the world, will always be free to come to its own conclusions on the facts of a case. That has to be the right approach compared to knee-jerk ad hoc changes that can eventually skew what was a balanced interpretation of OECD's original policy. For example, the commentary already make it abundantly clear that the parent subsidiary relationship per se is not sufficient of itself to constitute either company a permanent establishment of the other.
So, it is one thing to propose commentary change that reflects ways that the business world may have progressed in a modern world (and is consistent with the rest of the Commentary and does not contradict it), but entirely another to suggest as some private contributors have, free standing amendments that would shift the existing boundaries. For example, business has suggested that the question of whether a subsidiary constitutes a permanent establishment of another company in the same group should be determined 'without regard to the subsidiary's factual or legal relationship' with the other company.
I have to say that that does not seem right: it is impossible to form a view on whether one company constitutes a permanent establishment of another without looking at the factual and legal relationship between them. The Commentary says now that a subsidiary can constitute a permanent establishment of its parent if, for example, it has and habitually exercises an authority to conclude contracts in the name of the parent company.
I don't find suggestions that actually undermine what the Commentary says now particularly attractive. We will continue to consider the issues here
I am sure that the OECD will be able to rise to these challenges in the years and decades ahead, working with partners in non-OECD economies and the wider business community. Ladies and gentlemen, thank you for listening.
