Double Tax Treaties: Practical Problems in Article 8 of the OECD Model Convention
© Springer-Verlag Berlin Heidelberg 2015Orestis Schinas, Carsten Grau and Max Johns (eds.)HSBA Handbook on Ship Finance10.1007/978-3-662-43410-9_13
13. Double Tax Treaties: Practical Problems in Article 8 of the OECD Model Convention
Rödl & Partner, Kehrwieder 9, 20457 Hamburg, Germany
Article 8 of the OECD Model Convention is a special provision in the Model Convention. It prevails over the permanent establishment principle of Article 7 and deals with the taxation of profits from the operation of ships in international traffic. The scope of this provision is confined to business operations in the maritime sector, but is of particular importance. The tax structures of many large shipping companies rely on Article 8 of the OECD Model Convention. Surprisingly, however, several questions remain unsolved. Court rulings hardly exist. Moreover, the OECD Commentary to Article 8 of the Model Convention is rather outdated; it has been amended only on rare occasions in the past. The main problems of Article 8 of the OECD Model Convention relate to the treatment of preparatory and ancillary activities, the use of containers, bareboat chartering and the definition of “international traffic”.
Article 8 of the OECD Model Convention deals with the taxation rights of states that have concluded double tax treaties with other contracting states regarding profits from the operation of ships in international traffic. Whether a state has permission to tax the respective profits inevitably influences the way how investors finance their investment. This is important for the state where the investment is financed as well as the vehicle through which it is financed; it is sensible to have the possibility of interest deduction in the same state where the profits are generated and taxed. This is true in principle, even if a tonnage tax regime is applicable.
13.1.1 Purpose of Double Tax Treaties
In today’s ever-developing economy, taxpayers are increasingly affected by the tax laws of more than one country. Most international businesses—from the individual entrepreneur to a large multinational corporate group—need occasional foreign tax advice or may even have to pay taxes abroad and not just in their home country. This is true for any business in the shipping industry, as this remains a truly international environment. Vessels, sailing boats and cruise ships of all kinds and sizes travel constantly across the oceans. A significant part of global trade is still carried out through boats.
The inherent trouble with multinational tax effects is that the tax laws of different autonomous countries are almost never coordinated; they are simply not “in tune”. This can result in double taxation for a specific taxpayer if two or more countries want to tax the same fact pattern at the same time. Naturally, double taxation has a harmful effect on the exchange of goods and services as well as on the movement of capital, technology and people. Even a double non-taxation may have a harmful effect, but such cases are hardly ever discussed in public. Removing the obstacles brought about by double taxation is unquestionably the only way of building economic relations between two or more countries.
This is where double tax treaties come into play. They aim at eliminating double taxation by dividing and distributing taxation rights among the contracting states. The state of residence usually has the sole taxation right. This state must also apply one of the two internationally recognized methods of avoiding double taxation—i.e. the exemption method and the tax credit method. The state of source, on the other hand, is usually entitled to either a restricted taxation right or no taxation right at all.
Within this setting, the “shipping article”—i.e. Article 8 of the OECD Model Convention—provides special rules regarding the elimination of double taxation on profits from the operation of ships in international traffic. The OECD Model Convention, which was first published in 1955, is recommended by the Council of the OECD and serves as a uniform basis for the most common problems arising from international double taxation. The Model Convention and the accompanying Commentary standardize, clarify and confirm the fiscal situation of taxpayers who are engaged in commercial, industrial, financial or other activities in other countries through the application by all countries of common solutions to identical cases of double taxation. Germany, for instance, has concluded more than 90 double tax treaties, most of which follow the suggestions of the OECD Model Convention. The same is true for most EU/EEA member states, but worldwide, states frequently use other models like the UN model or the US model. It is not mandatory for states to use any one of the models and a country faces no sanctions in case it negotiates its treaties in a way that differs from the model.
From the German point of view, the Commentary is crucial for taxpayers, particularly with respect to Article 8 of the OECD Model Convention, because there is hardly any German case law on it. Therefore, the Commentary provides guidance and help with respect to the interpretation of Article 8.
13.1.2 Brief History of Article 8 of the OECD Model Convention
Article 8 of the OECD Model Convention has a long history. As early as 1920, when the League of Nations first started working on international double taxation, the shipping industry had already experienced a major tax dispute between states. The United States and the UK had introduced special tax rules for the shipping industry, and Japan, Norway, Italy and France followed suit. Immediately after World War I, some states concluded bilateral treaties regarding the free transit of vessels navigating through international waters. These treaties included tax provisions for foreign shipping companies. In 1923, the Financial Committee of the League of Nations submitted a Report on Double Taxation with particular focus on maritime and air transport activities. The report was revised in 1925 by the resolution of a group of technical experts. These technical experts also published the first draft of a bilateral convention for the prevention of double taxation in 1927.
In 1931, the first draft of a multinational tax treaty was published. This convention reaffirmed the “centre of real management” as the decisive criterion for taxation rights in the shipping industry. In the following years, the Financial Committee of the League of Nations continued working on revisions of the existing draft conventions, but only in 1943 and 1946 were these discussions implemented into the Mexico and London Model Conventions. In these conventions, the “centre of real management” was still the crucial factor used to determine taxation rights. However, the Mexico Model Convention used the term “fiscal domicile” for the first time in history to represent the state where the shipping enterprise was incorporated. Naturally, placing emphasis on the place of incorporation rather than the place of effective management produces significantly different results.
In 1956, the Fiscal Committee of the OECD commenced work on double taxation, which led to the famous 1959 draft report. This report introduced the term, “place of effective management”, which was incorporated into Article 8 of the OECD Model Tax Convention in the year 1963. Ever since, Article 8 has remained largely unchanged, even though the Commentary has been amended several times. The changes and amendments were made with respect to preparatory and ancillary activities and the special rules presented in paragraphs 3 and 4 of Article 8 of the OECD Model Convention, but the principle of paragraph 1 remains the same.
13.1.3 Reflection of Article 8 in German Tax Treaties
220.127.116.11 Paragraph 1 of Article 8
Regarding the general rule set forth in Article 8 paragraph 1 of the OECD Model Convention, it must be noted that Germany has concluded a significant number of tax treaties that deviate from this rule. According to these treaties, the decisive factor is not the place of management of the enterprise that operates a ship, but the residence of the enterprise or the entrepreneur (e.g. tax treaties with Azerbaijan, Australia, Iceland, Indonesia, Japan, Canada, Kenya, Lithuania, Sweden, Turkey, the United States, Russia, Malaysia, Liberia, Latvia and the Philippines).
Deviation from the OECD Model Convention can lead to difficulties in determining tax residency in case partnerships are used for the operation of ships (this is not unusual, particularly under the German tonnage tax system). From the German perspective, if a partnership operates a ship in international waters, only the partners can be tax residents within the meaning of Article 3 paragraph 1 lit. d and Article 4 of the OECD Model Convention. As the partnership is tax-transparent under German tax law, it cannot be a resident of a contracting state. Qualification conflicts may arise if foreign countries qualify a partnership differently, and these conflicts may eventually result in a double taxation that cannot be eliminated.
Tax treaties with Singapore and Korea state that tax exemptions on shipping income shall be granted only if domestic tax residents do not control a foreign enterprise. For instance, consider a Korean corporation that has German tax residents as shareholders with a qualifying shareholding of more than 25 % (Singapore: 50 %). This corporation may rely on the tax exemption in Germany only if it can prove that the tax levied equals the tax that is usually levied without any allowances or tax benefits. The old treaty with Cyprus provided for a similar rule, but the new treaty as of 7 November 2011 lacks such a provision, and with good cause: the German Foreign Tax Act with its add-back rules is applicable as a tax treaty anyway.
Many German treaties, particularly the older ones, have special clauses for the taxation of income resulting from the leasing of containers (e.g. Denmark, Poland, India, Japan, Canada, Korea, Croatia, Norway, Malta, Russia, Sweden, Ukraine, Italy, Romania, Singapore, the United States and the United Arab Emirates).