Domestic Thin Capitalization Rules and the Non ...

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Unfinished Business: Domestic Thin Capitalization Rules and the NonDiscrimination Article in the OECD Model

Craig Elliffe* *LLB (Hons), BCom Otago and LLM Cantab, Professor of Taxation Law and Policy, University of Auckland, and Consultant, Chapman Tripp, Barristers and Solicitors. The author can be contacted at [email protected].

1. Introduction: Purpose and Approach Adopted

This article begins by explaining why there is a potential conflict between thin capitalization rules and tax treaties. A company has a choice in its funding between sourcing debt finance and equity finance and, in this context, domestic thin capitalization rules operate to address the “excessive” use of tax preferred debt finance. Thin capitalization regimes are designed to prevent hidden capitalization (the provision of debt financing, which is, in substance, equity capital). Non-discrimination rules, on the other hand, have a completely different focus and often result in adverse tax consequences for non-resident investors that do not apply to resident investors. It just so happens that often thin capitalization rules apply to entities that are controlled by non-resident investors.

This article seeks to ascertain the nature of the relationship between domestic thin capitalization rules and the non-discrimination article in the OECD Model (2010),1 with a

1.

OECD Model Tax Convention on Income and on Capital (22 July 2010) , Models IBFD.

2 particular focus on foreign ownership and article 24(5) (see sections 4. and 5.). The question is addressed in an international context to examine the issues that countries may have in common. Ultimately, whether or not thin capitalization rules are affected by tax treaties is a matter that is specific to a particular tax jurisdiction. The connection between domestic law and tax treaties depends on many different factors, i.e. how the thin capitalization rules operate, how the non-discrimination article in a tax treaty is framed and how, constitutionally, domestic anti-avoidance rules integrate with public international law obligations created by a tax treaty. Notwithstanding the specific application on a countryby-country basis, the issues confronted by each country are similar.2 This is why it is helpful to consider the overall international position before narrowing down the enquiry to a particular jurisdiction.

In this broad international context, a question arises regarding the interpretation of article 24(5) in circumstances where a thin capitalization regime applies to foreign owned entities. It has to be acknowledged (even by the OECD) that the interpretation of the nondiscrimination article is problematic. The reason for this is that the words of article 24(5) are clear. Article 24(5) of the OECD Model has not been recently amended. Instead, the Commentary on Article 24 of the OECD Model,3 over time, has sought to establish that the words in article 24(5) require a special meaning drawn from the overall context of a tax treaty. The OECD has imported an arm’s-length principle into the words of article 24(5), which simply does not exist when the words are read literally. This article addresses the way

2. This could also be regarded as an extension of the discussion regarding the application of domestic anti-avoidance rules to tax treaties. In this respect, thin capitalization is arguably a particular form of domestic anti-avoidance legislation. 3. OECD Model Tax Convention on Income and on Capital: Commentary on Article 24 (22 July 2010), Models IBFD.

3 the OECD, through its 1986 Report on "Thin Capitalisation" (the 1986 Report)4 and the Commentary on Article 24, has sought to make it clear that the thin capitalization rules should apply (within certain parameters).

Having ascertained the OECD’s position, the article then turns to examine recent international tax cases to ascertain the key factors in the operation of the nondiscrimination article and to compare and contrast them with the OECD’s position (see section 6.).

The problem that all countries encounter is how to rationalize domestic thin capitalization rules that may discriminate against non-residents with treaty obligations that prohibit such discrimination. The conclusion that the OECD has reached is that thin capitalization rules can apply where there is a tax treaty that has a non-discrimination article, despite the clear language in that article to the contrary. Recent case law generally supports this proposition, but also recognizes that, in some cases, the non-discrimination article prevails, i.e. either when the thin capitalization rules go too far and are in breach of an arm’s-length principle or when a contextual interpretation importing the arm’s-length principle is inappropriate.

In this latter circumstance of a contextual interpretation importing the arm's-length principle case law supports the view, that in respect of older treaties, the Commentary may not be an appropriate aid to the interpretation of Article 24 (5). This is because the tax treaty containing the non-discrimination article was concluded at a point in time before the

4. OECD, Report on “Thin Capitalisation” (OECD 1986), adopted by the OECD Committee on Fiscal Affairs on 26 November 1986.

4 OECD’s consensus view was well-established.5 Prior to discussing the non-discrimination article in depth, the background to the history and the current application of article 24 is considered (see section 2.). Why the article is currently receiving considerable attention in tax disputes and litigation is also speculated upon (see sections 2. and 3.).

2. Background: The History and Current Application of the Non-Discrimination Article

The principle of non-discrimination significantly predates the appearance, at the end of the 19th Century, of tax treaties.6 In order to extend and strengthen the diplomatic protection of their nationals, contracting states entered into arrangements to accord nationals of another state equality of treatment with their own nationals. These arrangements took a great many forms, such as consular or establishment conventions, and treaties of friendship or commerce. While provisions prohibiting tax discrimination by other countries have a long history, article 24(5) of the OECD Model, like the rest of article 24, is a more recent

5. For examples of these situations see sec. 6., and the discussion in respect of the decisions DE: BFH, 9 Feb. 2011, I R 54, 55/10, Re-Treaty Discrimination and Fiscal Unity, 13 Intl. Tax L. Repts. 6, p. 839 (2011), Tax Treaty Case Law IBFD and FR: CE, 30 Dec. 2003, Decision No. 233894, Re Société Andritz Sprout Bauer, 6 Intl. Tax L. Repts. 4, p. 604 (2004), Tax Treaty Case Law IBFD. Both cases concern disputes when the tax treaty containing the non-discrimination article was concluded at a point in time before the OECD’s consensus view was well-established in the OECD Model Tax Convention on Income and on Capital: Commentary on Article 24 (17 July 2008), Models IBFD. 6. Para. 6 OECD Model: Commentary on Article 24 (2010), although the ownership provision was first proposed in 1957 to OEEC Working Party 4 by the Swiss delegation who had concluded a similar provision in the Convention Between the Swiss Confederation and the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation with respect to Taxes on Income (30 Sept. 1954), Treaties IBFD (such non-discrimination articles being in general use by the United Kingdom from the early 1950s). For a discussion on the history of the provision, see J.F. Avery Jones, Understanding the OECD Model Tax Convention: The Lesson of History, 10 Fla. Tax Rev. 1 (2009) and J.F. Avery Jones et al., Art. 24(5) of the OECD Model in Relation to Intra-Group Transfers of Assets and Profits and Losses, 3 World Tax J. 2 (2011), Journals IBFD and Brit. Tax Rev. 5 (2011). Art. 24(5) is identical to the same article in the Draft Convention for the Avoidance of Double Taxation with respect to Taxes on Income and Capital (30 July 1963), Models IBFD.

5 development, appearing first in the OECD Draft Model (1963) where it has remained unchanged.7

Despite the continued inclusion of non-discrimination articles in international tax agreements, many of the concepts relating to non-discrimination seem somewhat illdefined. Article 24 contains five substantive paragraphs each of which has a significantly different focus.

Why is article 24 receiving a great deal of recent attention?8 Perhaps this phenomenon is being driven by sovereign nations forming even closer business and economic ties with neighbouring states. Certainly, non-discrimination has become a significant legal issue for the European Union, as a common market requires unfettered movement of goods, services, people and capital. The differential tax treatment of domestic and imported goods and services is an obstacle to a common market, as is the differential tax treatment of residents and non-residents especially where foreign investment results in international double taxation. This is why the European Union9 and the European Court of Justice (ECJ) are at the forefront of dealing with issues of non-discrimination. In their desire to establish a single market and to prevent the restriction on any EU entity’s freedom of establishment,

7. I. Nepote, Article 24-Non-Discrimination, in History of Tax Treaties-The Relevance of the OECD Documents for the Interpretation of Tax Treaties p. 663 (T. Ecker & G. Ressler eds., Linde 2011). 8. Although this is hardly scientific, it is interesting to note that since 2001 no less than 30 cases concerning art. 24 have been reported in the Intl. Tax L. Repts.. 9. See Treaty on the Functioning of the European Union of 13 December 2007, art. 110, OJ C115 (2008), EU Law IBFD.

6 the ECJ has upheld the principles of non-discrimination.10 In turn, this has led to an increased focus on article 24 of the OECD Model.11

In addition to recent litigation, there has been considerable academic interest in the nondiscrimination article. By way of an example, a group of distinguished authors discussed, in a recent article, the application of article 24(5) in the context of intra-group transfers of assets and profits and losses.12 These authors dispute the conclusion reached in the Commentary on Article 24 of the OECD Model that article 24(5) can never apply to grouping provisions where there is non-resident ownership. They advance reasons why the non-discrimination article does apply to some domestic law grouping provisions and assert that the OECD needs to provide a more sophisticated analysis of the topic in the Commentary. There is a similar need to reconcile the breadth of the wording in article 24(5) and the application of the thin capitalization rules.

3. What is the Problem with Thin Capitalization Regimes?

In overall terms, investors based in one country investing in a company based in another country (the source country) can usually reduce their tax in the source country by choosing to finance the company with debt rather than equity. In the words of the Committee on Fiscal Affairs, the consequence is “that it may sometimes, from a tax point of view, be more

10. See, for example, UK: ECJ, 8 Mar. 2001, Case C-397/98, Metallgesellschaft Ltd and Others, Hoechst AG and Hoechst (UK) Ltd v. Commissioners of Inland Revenue and HM Attorney General, ECJ Case Law IBFD and 3 Intl. Tax L. Repts. p. 385 (2001). 11. UK: HL, 23 May 2007, Boake Allen Limited; Bush Boake Allen Enterprises Limited; Bush Boake Allen Holdings UK Limited; Bush Boake Allen Inc; NEC Semi-Conductors Limited; NEC Corporation; Acushnet Limited; Acushnet International Inc; Gallaher Limited v. H M Revenue and Customs [2007] UKHL 25, 9 Intl. Tax L. Repts. p. 995, [2007] STC 1265 and [2007] 1 WLR 1386 at [16], Tax Treaty Case Law IBFD. 12. Avery Jones et al., supra n. 7.

7 advantageous to a particular combination of company contributor to arrange the financing of the company by way of loans rather than by way of equity contributions”.13

Given this dynamic, it is easy to see that the investors in the company may decide to provide what is, in substance, equity capital in the form of debt financing (this is referred to in the 1986 Report as “hidden capitalization”).14 Tax authorities are concerned with this tax driven preference for debt finance and have devised a number of approaches to deal with what they regard as the problem of hidden capitalization. These rules are normally known as thin capitalization rules, as they are designed to prevent the excessive use of debt and the corresponding lack of equity funding.

Some of the responses to the thin capitalization problem examine the relationship of the creditor to the entity concerned and recognize that the occurrence of hidden capitalization is greater where funding is provided by majority shareholders or associated companies. Other approaches to the problem of hidden capitalization recognize that there can be some circumstances in which unacceptable tax advantages, such as a back-to-back loan where the majority shareholder of the domestic entity lends to an arm’s-length third party who onlends to the domestic entity, are provided when funding is by a loan from an unconnected party.15 Accordingly, the rules differ from country to country in that sometimes they are aimed at associated parties lending exclusively, while others consider total indebtedness from all sources.

13. 14. 15.

OECD, supra n. 4, at para. 10. Id. Id., at para. 14.

8 Another response to the problem is the use of earnings-stripping legislation that restricts the deduction of interest expense on related-party debt. Such earnings-stripping legislation usually specifies an interest-coverage ratio, such as net interest expense as a proportion of taxable income and limits deductions where the interest expense exceeds this ratio.16

Some countries adopt a “fixed ratio” approach on the basis that certainty in having a safeharbour for taxpayers is desirable. If a company’s total debt exceeds a proportion of its equity, or total assets, the interest on the loan, in excess of the fixed ratio, is either disallowed as a deduction, treated as income, or both. Some countries apply these rules only to loans from associated parties but others apply their regimes to loans from both associated and non-associated parties.

One or more of the features listed above are usually present in a modern regime designed to counter hidden capitalization. The particular feature that is the focus of this article, is, however, the presence of foreign ownership as a precondition to the operation of the thin capitalization regime.

Frequently, these domestic thin capitalization rules target entities or companies that are owned by non-residents of the country concerned. The fundamental reason for this is that hidden capitalization is only a problem cross border. Where the investor is in the same jurisdiction and elects to fund the company by way of debt rather than equity the deduction for interest expense corresponds to the interest income earned by the investor. The rate of 16. In the United States, for example, the earnings stripping rules generally apply to a corporation with a debt-to-equity ratio in excess of 1.5 to 1 where its net interest expense exceeds 50% of its adjusted taxable income for the year and if the interest expense is not subject to full US income or withholding tax in the hands of the recipient.

9 tax for the two taxpayers, i.e. the company and the investor, is the only point of potential difference. Some thin capitalization regimes can, therefore, apply to companies that are owned or controlled by non-residents, but do not apply if the same company is owned or controlled by a resident. In other words, such thin capitalization regimes are inherently discriminatory to the extent that they provide for adverse tax consequences for nonresident investors, but not for resident investors.17

4. The Paragraphs of Article 24 that are Potentially Relevant to Domestic Thin Capitalization Rules

The 1986 Report18 identified that article 24 of the OECD Model may prevent the application of the thin capitalization rules if those rules only apply in respect of payments to nonresidents, in contrast to residents, or if the rules disallow the deduction of interest in circumstances where a company is controlled by non-residents but allow for a deduction if the company is controlled by residents. Articles 24(4) and (5) are relevant in the context of this discussion.

Article 24(4) requires that interest paid by an enterprise of a contracting state to a resident of the other contracting state be deductible under the same conditions as if it had been paid to a resident of the first-mentioned state.19 Paragraph 4 examines the residency of the

17. In regard to debt actually held by those investors (art. 24(4) of the OECD Model) or in the case of companies owned and controlled by non-residents (art. 24(5) of the OECD Model). 18. OECD, supra n. 4, at para. 66, in noting that the reference to art. 24(5) and (6) in the 1986 Report now relate to paragraphs (4) and (5) of art. 24(4) and (5) of the OECD Model (2010). 19. Art. 24(4) of the OECD Model (2010) reads as follows: “Except where the provisions of paragraph 1 of Article 9, paragraph 6 of Article 11, or paragraph 4 of Article 12, apply, interest, royalties and other disbursements paid by an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if

10 lender and ensures that, when interest paid to a resident is deductible, the deduction is not disallowed or restricted when interest is paid to a non-resident.

Article 24(4) is expressly subject to the provisions of articles 9(1), 11(6) and 12(4) of the OECD Model (2010). These overriding paragraphs are all concerned with ascertaining the profits on an arm’s-length basis. Article 24(4) was introduced into the OECD Model (1977).20 It has remained unchanged since then, as has the key part of the Commentary on Article 24 of the OECD Model explaining its role.21 The Commentary on Article 24 concerns itself simply with confirming what the OECD Model says, i.e. that article 24(4) applies when a payment applies only to non-resident creditors and is in breach of the arm’s-length requirements of article 9(1), etc. The Commentary on Article 24(4) does not explain why this arm’s-length override exists, presumably because the reason is obvious.22

Article 24(5) of the OECD Model precludes a contracting state from imposing less favourable treatment on an enterprise when the capital of that enterprise is owned or controlled, wholly or partly, directly or indirectly, by one or more residents of the other contracting state. There is no exception in article 24(5) for the arm’s-length principles in article 9(1), etc.

they had been paid to a resident of the first-mentioned State. Similarly, any debts of an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purposes of determining the taxable capital of such enterprise, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned State”. 20. OECD Model Tax Convention on Income and on Capital (11 Apr. 1977), Models IBFD. 21. Nepote, supra n. 7, at p. 680. See para. 74 OECD Model: Commentary on Article 24 (2010), which is the same as para. 56 OECD Model: Commentary on Article 24 (1977). 22. More information on the role of these arm’s-length provisions and their relationship to art. 24 (5) is contained in para. 79 OECD Model: Commentary on Article 24 (2010), but the most illuminating discussion is contained in OECD, supra n. 4.

11 Article 24(5) reads:23 Enterprises of a Contracting State, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the firstmentioned State are or may be subjected.

This provision, notwithstanding the provisions of article 1, also applies to persons who are not resident in one or both of the contracting states.

In summary, article 24(4) prohibits the disallowance of a deduction for interest paid to a non-resident creditor when the deduction would be allowed if the interest were paid to a resident creditor. Article 24(4) is, however, expressly subject to an exception for any domestic thin capitalization regime that meets the arm’s-length requirements of article 9(1) et al. Article 24(5), at face value, regards, as discriminatory, the disallowance of an interest deduction in circumstances where a company is controlled by non-residents, whereas the interest deduction would be allowed if the company were controlled by residents. In contrast to article 24(4), article 24(5) is not qualified by any arm’s-length exceptions. Many thin capitalization regimes are structured to apply where there are non-resident related creditors. Some regimes, however, apply only where entities in a state are controlled by non-residents and this is the focus of this article given the wording in article 24(5).

23. Art. 24(5) of the OECD Model (2010) is the “base case” for many countries. Some countries significantly modify art. 24(5) with provisos limiting the application of the foreign-owned capital nondiscrimination article.

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5. Does Article 24(5) of the OECD Model Mean What It Says?

5.1. What is the relationship between article 24(5) and domestic thin capitalization rules?

At the heart of this enquiry is the question of whether article 24(5) should be read literally or whether some additional meaning should be inferred, contextually, perhaps with the benefit of the OECD Commentary on the OECD Model (2010).24

On its face, for article 24(5) to apply, the following three requirements must be present: (1)

an enterprise in one state is owned by a resident of the other state, i.e. the capital25 of the domestic enterprise must be owned by a non-resident of the enterprise’s state;

(2)

it does not matter that the capital is wholly or partly owned or controlled, nor does it matter whether the ownership is direct or indirect;26 and

24. See the description of the interpretive process given by K. Vogel, The Influence of the OECD Commentaries on Treaty Interpretation, 54 Bull. Intl. Fiscal Documentation 12, sec. III. (2000), Journals IBFD. 25. It is noted by the authors of the General Report in respect of Subject 1 of the 2008 Brussels Congress of the 62nd International Fiscal Association (Luc Hinnekens and Philippe Hinnekens) that capital appears to exclude partnerships which, according to the domestic law of the state in which they are established, do not have such capital. See L. Hinnekens & P. Hinnekens, General Report (and Branch Reports), Non-discrimination at the crossroads of international taxation, Cahier De Droit Fiscal International vol. 93a (Sdu Fiscale & Financiële Uitgevers 2008), Online Books IBFD. 26. An example of indirect ownership can be found in the Finnish case FI: KHO, 22 June 2004, 2004:65, Tax Treaty Case Law IBFD. In this case a US company was owned by Finnish subsidiaries via an interposed Bermudan holding company. Under Finnish domestic law a group contribution between the two subsidiaries was not deductible, as the required 90% ownership could only be acquired through domestic companies. In holding that the domestic provisions were in breach of the Convention Between the Government of the United States of America and the Government of the Republic of Finland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital (21 Sept. 1980), Treaties IBFD, the court made it clear that indirect control was sufficient for the US company to be entitled to the application of art. 24(5). This case is referred to in the Finnish Report in respect of Subject 1 of the 62nd Congress of the International Fiscal Association; see S. Penttilä, Finland, Non-discrimination at the crossroads of international taxation, supra n. 25, at sec. 2.3.4.

13 (3)

the foreign-owned enterprise must be subjected, in the enterprise’s state, to a more burdensome level of taxation than other similar enterprises owned by someone else.

Article 24(5) does not make it clear whether the comparison in (3) is between a domestic enterprise owned by residents of the same state as the enterprise or whether the owners might be residents of a third country. It appears to be clear, for three reasons, that it is the former, i.e. the comparison should be made to a domestic entity owned by domestic state owners. First, in a major review by the OECD in 2008 to examine the interpretation and application of article 24 presented in the discussion document “Application and Interpretation of Article 24 (Non-Discrimination)”,27 the Committee on Fiscal Affairs expressly considered these two alternatives and concluded that the comparison should be made with resident state owners and that there was no need to clarify this issue in the Commentary on Article 24 of the OECD Model (2010). Second, most countries requiring the comparison to be made with a third country owner expressly state, in the equivalent to article 24(5), that the comparison should be with enterprises where the capital is owned “by one or more residents of a third State”. Third, some courts in France and the United Kingdom have expressly considered this point and concluded that the comparator enterprise is one controlled in the state that is alleged to have applied other or more burdensome taxation.28

27. OECD, Application and Interpretation of Article 24 (Non-Discrimination) (OECD 2008), adopted by the OECD Committee on Fiscal Affairs on 20 June 2008. 28. Re Société Andritz Sprout Bauer (2003) and UK: HC, 24 Nov. 2003, NEC Semi-Conductors Limited v. Revenue and Customs Commissioners, (Ch), 6 Intl. Tax L. Repts. p. 416 at p. 433 (2004) and [29], Tax Treaty Case Law IBFD, which went on to the House of Lords as Boake Allen Limited; Bush Boake Allen Enterprises Limited; Bush Boake Allen Holdings UK Limited; Bush Boake Allen Inc; NEC Semi-Conductors Limited; NEC Corporation; Acushnet Limited; Acushnet International Inc; Gallaher Limited NEC Semi-Conductors Limited (2007).

14 A literal reading of article 24(5) raises questions of some significance for a domestic thin capitalization regime that applies to foreign-owned entities, but, that does not, by comparison, apply to domestically-owned entities. What light does the OECD shed on the application of article 24(5) to thin capitalization regimes?

5.2. The Commentary on Article 24 of the OECD Model

The Commentary on Article 24 of the OECD Model (2010) contains a series of important statements regarding the application of the non-discrimination article to domestic thin capitalization regimes. First, it states that the object of article 24(5) is “to ensure equal treatment of taxpayers residing in the same State, and not to subject foreign capital, in the hands of the partners or shareholders, to identical treatment to that applied to domestic capital” (emphasis added).29 From this statement, it is clear that the Committee is clarifying that the provision relates to the prevention of discrimination in regard to the taxation of the enterprise itself and not the persons owning or controlling the capital.

Second,30 it identifies that no conflict exists with article 24(5) where a state’s domestic thin capitalization rules disallow deductions of interest paid to non-resident associates, provided, however, that the treatment would be the same if the interest had been paid to a non-resident associate enterprise that did not itself own or control any of the capital of the taxpayer.31 The discussion document prepared by the Working Party32 records the Committee on Fiscal Affair’s conclusion that the payment of interest from a resident 29. 30. 31. 32.

Para. 76 OECD Model: Commentary on Article 24 (2010). Para. 79 OECD Model: Commentary on Article 24 (2010). Id. OECD, supra n. 27, at para. 87.

15 enterprise to a non-resident related creditor, i.e. simply on the basis of the debtor-creditor relationship, would generally be outside the scope of article 24(5), as the focus of paragraph 5 is to address discrimination based on foreign ownership of the capital of the enterprise.

Third, the OECD Commentary on Article 24 advances a more controversial interpretation.33 It imports a restriction that is imposed upon article 24(4) relating to certain arm’s-length transfer pricing requirements and applies it to article 24(5), even though paragraph 5 of the OECD Model itself contains no such qualification.

Article 24(4) proscribes discrimination in respect of deductions for certain payments, i.e. interest, royalties and other disbursements, made by an enterprise of a contracting state to a resident of the other contracting state requiring a similar deductible tax treatment “under the same conditions” as if it had been paid to a resident of the enterprise’s contracting state. In other words, a regime that provides for a deduction to an enterprise of the first state when the payment of certain expenses is made to a domestic resident payee of that state would be discriminatory, unless a deduction is available to the enterprise when it makes a payment to a contracting state’s non-resident payee.

Article 24(4), however, commences with the qualifying words “[e]xcept where the provisions of paragraph 1 of Article 9, paragraph 6 of Article 11, or paragraph 4 of Article 12, apply, ...”. The OCED Commentary on Article 24(4) sheds some light on this qualification as follows:34

33. 34.

Para. 79 OECD Model: Commentary on Article 24 (2010). Para. 74 OECD Model: Commentary on Article 24 (2010).

16 Paragraph 4 does not prohibit the country of the borrower from applying its domestic rules on thin capitalisation in so far as these are compatible with paragraph 1 of Article 9 or paragraph 6 of Article 11. However, if such treatment results from rules which are not compatible with the said Articles and which only apply to nonresident creditors (to the exclusion of resident creditors), then such treatment is prohibited by paragraph 4.

Discriminatory tax treatment normally prevented by article 24(4) can, therefore, occur in situations where the domestic rules meet the requirements of articles 9(1), 11(6) and 12(4).

When the Working Party, in 2008, examined “whether and to what extent the current wording of paragraphs 4 and 5 can be interpreted to allow the application of thin capitalization rules and whether any clarification is necessary in this regard”,35 it noted that paragraph 74 of the Commentary on Article 24 of the OECD Model (2010), then paragraph 56, dealt with the issue of the relationship between thin capitalization rules and article 24(4) of the OECD Model. It concluded the following in respect of article 24(5):36

The Committee also agreed that the Commentary should clarify that even in cases where thin capitalisation rules apply only to enterprises of a Contracting State the capital of which is wholly or partly owned or controlled, directly or indirectly, by nonresidents, these rules do not violate paragraph 5 to the extent that they result in adjustments to profits that are made in accordance with paragraph 1 of Article 9 or paragraph 6 of Article 11. 35. 36.

OECD, supra n. 27, at para. 83. Id., at para. 88.

17

The consequence of this was the insertion in paragraph 79 of the OECD Commentary on Article 24 of the OECD Model (2010) of a parallel “except where ...” test in respect of article 24(5), which does not exist in article 24(5) itself. The OECD Commentary explains the need to import the transfer pricing arm’s-length test into article 24(5) as follows:37

Indeed, since the provisions of paragraph 1 of Article 9 or paragraph 6 of Article 11 form part of the context in which paragraph 5 must be read (as required by Article 31 of the Vienna Convention on the Law of Treaties), adjustments which are compatible with these provisions could not be considered to violate the provisions of paragraph 5.

There is little discussion on the introduction of the transfer pricing exception to article 24(4) of the OECD Model (2010), which makes the import of the arm’s-length exclusion into another non-discrimination paragraph, i.e. article 24(5) curious.38 The difference between article 24(4) and (5) may, however, be explained by the fact that article 24(4) was added to the OECD Model (1977),39 whereas article 24(5), as discussed in section 2., had its origins in the 1950s and is found in the OECD Draft Model (1963). In other words, article 24(4) is a modern addition, whereas article 24(5) had much earlier origins.40

5.3. Other OECD reports

37. Para. 79 OECD Model: Commentary on Article 24 (2010). 38. Nepote, supra n. 7, at p. 680. 39. Id. 40. What is unusual about all of this is that it took from 1977 until 2008 to modify the Commentary on Article 24(5).

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The OECD’s view of the relationship between article 24(4) and (5), as evidenced by the adoption of the changes to article 24 of the OECD Model (2008),41 was foreshadowed by the 1986 Report.42

First, the writers of the 1986 Report (the Committee on Fiscal Affairs) expressly recognized the breadth of the wording of article 24(5) and simultaneously acknowledged that the Commentary on Article 24 of the OECD Model (1977)43 leaves this point unaddressed:44

On the face of it this provision might, it has been argued, prevent the operation of rules which disallow the deduction of interest paid to non-resident shareholders of companies controlled by non-residents if under similar circumstances, the interest would be deductible for a company which was not controlled by non-residents. The Commentary on this paragraph does not deal with the point.

Second, the Committee concluded that article 24(5)45 was relevant, in principle, to thin capitalization rules. The wording was, however, very general and was broadly aimed at preventing “tax protectionism” and did not deal with measures introduced to prevent the transfer of profits in the guise of interest. Due to the broad nature of article 24(5), the Committee concluded it needed to “take second place”46 to more specific provisions in a tax treaty. This led to the conclusion: “[t]hus Article 24(5) (now 25(4)) [referring to articles 9(1) 41. OECD Model Tax Convention on Income and on Capital (17 July 2008), Models IBFD. 42. OECD, supra n. 4. 43. OECD Model Tax Convention on Income and on Capital: Commentary on Article 24 (11 Apr. 1977), Models IBFD. 44. OECD, supra n. 4, at para. 46. 45. Id., but referred to as paragraph 6 as it related to the OECD Model (1977). 46. Id., at para. 66(b).

19 and 11(6)] takes precedence over it in relation to the deduction of interest”.47 In this regard, the Commentary on Article 24 of the OECD Model (1992) reflected this conclusion as follows:48

Paragraph 5, though relevant in principle to thin capitalisation, is worded in such general terms that it must take second place to more specific provisions in the Convention. Thus paragraph 4 (referring to paragraph 1 of Article 9 and paragraph 6 of Article 11) takes precedence over this paragraph in relation to the deduction of interest.

In examining the role of these more specific provisions (article 9), the Committee discussed whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment. Article 9 allows a tax authority to adjust the taxable profits of an enterprise to include profits that are not in its accounts, but, which would have accrued to it in an arm’s-length situation. An adjustment that would disallow the interest expense and restore the taxable profits of the enterprise that would have been derived on an arm’slength basis, conforms with article 9(1). The essence of the arm’s-length exception to the non-discrimination rules was, therefore, as follows:49

Provided therefore that the re-categorisation of interest as a distribution of profit under domestic thin capitalisation rules has the effect of including in the profits of a

47. Id. 48. OECD Model Tax Convention on Income and on Capital: Commentary on Article 24 para. 58 (1 Sept. 1992). Para. 58 was added by the OECD Report entitled “The Revision of the Model Convention”, adopted by the Council of the OECD on 23 July 1992 on the basis of the previous OECD Report (see OECD, supra n. 4). 49. OECD, supra n. 4, para. 49.

20 domestic enterprise only profit which would have accrued to it in the arm’s-length situation there is nothing in Article 9 to prevent operation of those rules.

5.4. Conclusions on article 24(5) of the OECD Model and the application of domestic thin capitalization rules

While acknowledging that this issue is jurisdiction specific, the following three general conclusions may be drawn as to the OECD’s view on the relationship between article 24(5) of the OECD Model and the application of domestic thin capitalization rules: (1)

Article 24(5) potentially applies to thin capitalization rules. Certainly, there is no limitation in the language of the OECD Model itself, which means that, read literally, foreign ownership of a domestic entity should not result in the application of thin capitalization rules when domestic ownership is exempted from the thin capitalization regime. The OECD Committee on Fiscal Affairs acknowledged that deficiency in 1986 (“ ... The Commentary on this paragraph does not deal with the point”).50 This led to changes in the Commentary on Article 24 of the OECD Model (2008),51 although these changes were intended to “clarify” that thin capitalization rules do not violate article 24(5) to the extent that they result in adjustments that are in accordance with the arm’s-length principle.52

(2)

Citing article 31 of the Vienna Convention on the Law of Treaties (the “Vienna Convention”) 196953 as authority for the OECD Commentary means that a contextual

50. 51. 52. (2010). 53.

Id., at para. 46. (see also OECD, supra n. 27, at para. 83). OECD Model: Commentary on Article 24 (2008). See OECD, supra n. 27, at para. 88 and now para. 79 of the OECD Model: Commentary on Article 24 Vienna Convention on the Law of Treaties (23 May 1969), Treaties IBFD.

21 or systematic basis of interpretation was applied54 to import a restriction included in article 24(4), i.e. an arm’s-length transfer pricing type of exception, into article 24(5). The 1986 Report indicates that this is a solution to the problem caused by the wording of article 24(5), which is too broad and would otherwise permit the transfer of profits in the form of interest.55 Without limitation, this breadth of application of the non-discrimination principle would make the domestic thin capitalization rules of many countries ineffective. (3)

The Committee’s view is that, where thin capitalization rules are inconsistent with articles 9(1) or 11(6) of the OECD Model (2010), a residual non-discrimination power exists in article 24(5). The object of the paragraph is to deter, through tax measures, inbound investment (tax protectionism), rather than to interfere with the rules that prevented the transfer of arm’s-length profits in the guise of interest.56 This view led to the Commentary on Article 24 of the OECD Model (1992), which reflected the 1986 Report’s conclusions. From 1992 onwards (at least) but perhaps from 1986, countries negotiating article 24(5) should have been aware that the nondiscrimination article would not interfere with thin capitalization rules that did not offend the arm’s-length principle.

54. For a discussion on the general principles of interpretation of the Vienna Convention (1969) and public international law generally, see N. Shelton, Interpretation and Application of Tax Treaties p. 166 (LexisNexis 2004), where that author traces the three main approaches to treaty interpretation: (1) textual (or the ordinary meaning of the words), which analyses the actual words in the text of the tax treaty: (2) the intention of the parties’ (or founding fathers) approach, which attempts to ascertain the parties’ intention and then construes the tax treaty to give effect to those intentions; and (3) the aims or objects (or teleological) approach, which seeks to ascertain the tax treaty’s aims and objects, the tax treaty being construed to give effect to these aims and objects. Slightly different terminology is used by H. Pijl, The Theory of the Interpretation of Tax Treaties, with Reference to Dutch Practice, 51 Bull. Intl. Fiscal Documentation 12, sec. II.A. (1997), Journals IBFD. He describes the instruction for the interpretation of treaties in art. 31(1), i.e. “A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in the context and in the light of its object and purpose”, as combining the grammatical (“ordinary meaning”), teleological (“object and purpose”) and systematic (“context”) methods without giving preference to any one method. 55. OECD, supra n. 4, at para. 66(b). 56. OECD, supra n. 4, at para. 66(b).

22

Having considered the terminology of the OECD Model and the Commentary on it, the author now turns to the approach adopted by the courts in interpreting article 24(5) and, in particular, focuses on the extent to which the words in the article have been “read down” or narrowed to limit the scope of application of the article. Some of these decisions concern article 24(5) and its application to thin capitalization rules, while others involve the application of article 24(5) to company grouping and fiscal unity provisions. A feature in many of these judgements is a reference to decisions of foreign courts to assist in the interpretation of article 24 with the objective of establishing a common interpretation.57 In examining article 24, judges, in recent decisions in Germany and the United Kingdom, for example, appear to draw considerable assistance from the decisions and reasoning of overseas courts.58

6. Guidance from Recent Court Decisions

6.1. Distinguishing specific outcomes and looking for general principles

57. The introduction to the OECD Model (2010) at para. 5 refers to the desirability of “agreement on a common interpretation”. 58. With regard to Germany, see DE: BFH, 8 Sept. 2010, R 6/09, Re Shareholder Discrimination by German Thin Capitalisation Rules, 13 Intl. Tax L. Repts. 5, p. 646 (2011), referring to DE: ECJ, 12 Dec. 2002, Case C-324/04, Lankhorst-Hohorst GmbH v. Finanzaint Steinfurt, ECJ Case Law IBFD and 5 Intl. Tax L. Repts. p. 467 (2002). With regard to the United Kingdom, see, for example, the references made by Avery Jones and Sadler JJ in UK: FTT, 1 Apr. 2010, FCE Bank plc v. Commissioners for HM Revenue and Customs, 12 Intl. Tax L. Repts. p. 962 (2010), Tax Treaty Case Law IBFD, to the Netherlands Supreme Court, the Finnish Supreme Administrative Court and the Swedish Supreme Administrative Court, and the House of Lords in Boake Allen Limited; Bush Boake Allen Enterprises Limited; Bush Boake Allen Holdings UK Limited; Bush Boake Allen Inc; NEC Semi-Conductors Limited; NEC Corporation; Acushnet Limited; Acushnet International Inc; Gallaher Limited NEC Semi-Conductors Limited (2007), referring to the ECJ in Metallgesellschaft Ltd and Others (C-397/98).

23 The conclusion that sometimes thin capitalization rules prevail over the non-discrimination article and sometimes they do not is somewhat puzzling.

In November 2011, the Supreme Arbitration Court of Russia (Visshyi Arbitrazhnyi Syd Rossi’iskoi Federatcii) delivered a judgement59 regarding the application of the Russian thin capitalization rules in circumstances involving international tax treaties.60 The Russian court held that the non-discrimination article did not prevent the application of the Russian thin capitalization rules.

In contrast, in Spain, the Spanish Supreme Court (Tribunal Supremo)61 came to the opposite conclusion in respect of the Spain-United States Income Tax Treaty (1990).62 The Court followed two earlier decisions,63 relating to the Spain–Switzerland Income and Capital Tax Treaty (1966), which held that the Spanish thin capitalization rules are incompatible with the non-discrimination clause in that tax treaty and that those treaty provisions must take priority and thereby make the Spanish thin capitalization rules ineffective.

59. RU: SAC, 15 Nov. 2011, Ugolnaya kompania Severniy Kuzbass, Presidium Ruling No. 8654/11, Tax Treaty Case Law IBFD. 60. The applicable tax treaties were the Agreement Between the Government of the Republic of Cyprus and the Government of the Russian Federation for the Avoidance of Double Taxation with respect to Taxes on Income and on Capital (5 Dec. 1998), Treaties IBFD and the Agreement Between the Swiss Confederation and the Russian Federation for the Avoidance of Double Taxation with respect to Taxes on Income and on Capital (15 Nov. 1995), Treaties IBFD. 61. ES: TS, 7 Dec. 2011, Decision No. 451/2008. 62. Convention Between the United States of America and the Kingdom of Spain for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (22 Feb. 1990), Treaties IBFD. 63. There are two separate rulings by the Spanish Supreme Court, i.e. ES: TS, 17 Mar. 2011, Appeal No. 5871/2006 and ES: TS, 2 Nov. 2011, Appral No. 3196/2007, both involving the Convention Between Spain and the Swiss Confederation for the Avoidance of Double Taxation with respect to Taxes on Income and Capital [unofficial translation] (22 Apr. 1966), Treaties IBFD.

24 Why are courts coming to apparently opposite conclusions? Obviously, one answer to this is the nature of the domestic thin capitalization rule concerned. That analysis can only occur on a jurisdiction-specific basis and the answer may be unique to that jurisdiction. Nevertheless, some observations can be applied at a universal level before overlaying an individual country and/or treaty analysis. It is, therefore, helpful to examine these decisions in the context of the clear words of the tax treaty involved and the modifications proposed by the Commentary on Article 24 of the OECD Model. In other words, have the courts applied the OECD Commentary on Article 24 and taken the same view as the OECD Committee on Fiscal Affairs?

6.2. Three general principles

6.2.1. Initial comments

Recent court decisions involving the application of article 24(5) of the OECD Model to various issues, i.e. group offsets or fiscal unity, as well as thin capitalization, highlight the need to examine three significant questions to determine how the non-discrimination article interacts with domestic thin capitalization regimes.

First, how broadly have the courts interpreted the non-discrimination article? Have they included “indirect or covert” forms of discrimination in a broad principle based test or have they limited the discrimination to a “direct” type? Covert discrimination occurs when the relevant tax measure does not directly distinguish between two categories of taxpayers, but, in substance, has that effect by applying almost exclusively to non-nationals. These may

25 be cases where it is virtually impossible for a foreign taxpayer to meet the specific conditions of the tax provision, although the wording of the provision does not exclude foreign taxpayers.

Second, what exactly is the relationship or nexus required between the foreign ownership requirement of the non-discrimination article and the application of the thin capitalization rules? Where foreign ownership is a feature of the thin capitalization rules, do these rules apply solely because the enterprise is foreign owned? Does it matter that other conditions are also requirements of the thin capitalization rules? The answer to this question is also informative as to the type of discrimination, i.e. indirect or direct, discussed in the previous paragraph. The greater the causal relationship between foreign ownership and the nondiscrimination article, the more likely the discrimination is directly related to foreign ownership.

Third, what can the courts say concerning the relationship between an arm’s-length rule designed to prevent the transfer of profits and the foreign ownership non-discrimination article? Is the broad wording of article 24(5) to be read down to be consistent with articles 9(1) or 11(6)? Have the courts interpreted a tax treaty by reading into the meaning of article 24(5) the type of restriction contained in the wording of article 24(4) of the OECD Model? Have they followed the guidance given in the OECD Commentary on Article 24?

These topics are now considered in sections 6.2.2., 6.2.3. and 6.2.4., respectively.

6.2.2. Covert or indirect discrimination?

26

As noted in section 2., increased awareness of the principle of non-discrimination in tax treaties may be due to the influence of EU law, such as the German Federal Fiscal Court (Bundesfinanzhof, BFH) decision in Re Shareholder Discrimination,64 in which the nondiscrimination article (article 25(3)) of the Germany-Switzerland Income and Capital Tax Treaty (1971),65 which equates to article 24(5) of the OECD Model, was held to override the German thin capitalization rules. Significantly, this case involved the Germany-Switzerland Income and Capital Tax Treaty (1971), which predates the introduction of article 24(4) of the OECD Model (1977), and the subsequent discussion on the relationship between thin capitalization rules and the non-discrimination article in the OECD Commentary on Article 24 of the OECD Model, including the substantial revisions to the OECD Commentary on Article 24 of the OECD Model (2008).

The case involved a Swiss company that acquired land and built a hotel in Germany and borrowed money from its individual shareholder and from an associated company (owned by the individual shareholder). As the Swiss incorporated company’s management and control was exercised in Germany, the company was a resident of that country. The Swiss company was solely owned by a Swiss domiciled shareholder. The German tax authorities applied the German thin capitalization rules to interest payments made on loans from the shareholder and another Swiss company owned by the Swiss shareholder. As a consequence of the application of thin capitalization rules, an interest deduction was disallowed, as the tax authority asserted that this was effectively a distribution of profits in disguise. As

64. Re Shareholder Discrimination by German Thin Capitalisation Rules (2009). 65. Convention Between the German Federal Republic and the Swiss Confederation for the Avoidance of Double Taxation with respect to Taxes on Income and on Capital (11 Aug. 1971), Treaties IBFD.

27 indicated previously in this section, the BFH held that the non-discrimination article overrode the domestic thin capitalization rule. With effect from 2004, the German thin capitalization rules were extended to include domestic cases. As such, the thin capitalization rules, since that change, are unlikely to be regarded as discriminatory.

There are two interesting issues that arise from this decision. The first is whether or not the German thin capitalization rules were held to be directly or covertly discriminatory. The second relates to the relationship between article 24(5) and the arm’s-length financing exception. Under the earlier version of the German thin capitalization rules,66 a criteria for the application of the regime was that the owner of the entity involved was not entitled to a tax credit under the German imputation system.67 In the vast majority of cases, the reason why a tax credit was not available to the shareholder was that such shareholder was not a resident of Germany. That said, German resident shareholders, such as public bodies or charities, were also ineligible. The thin capitalization rules were changed in 2001. One of the features of the new regime was that it applied to interest paid to an owner of the borrowing corporation when that interest was not subject to German taxation.68 Like the pre-2001 regime, the new thin capitalization rules were, most likely, to affect foreign owners to whom the interest was paid, but could also apply, for example, to German residents such as tax-exempt charities.

66. DE: Corporate Income Tax Law (Körperschaftsteuergesetz, KStG) 1999, sec. 8a, National Legislation IBFD, which was in force until 2000. 67. Under this imputation regime, a tax credit could be passed to the owner of a German company when profits were distributed from the company, with a tax credit attached to the distribution representing tax paid by the German company, preventing double taxation of company profits. 68. Sec. 8a.1.1.2 KStG (new version).

28 Viewed in this light, the German thin capitalization rules that were in dispute are examples of covert or indirect discrimination, in that they do not make it a condition of application that the borrowing entity had a non-German owner. The BFH held, however, that it was irrelevant that the thin capitalization rules did not apply directly because of the shareholders’ place of residence.69 It was also irrelevant that the rules could be applied to corporations with German shareholders.70 The BFH referred to the judgement of the ECJ in Lankhorst-Hohorst (Case C-324/00), viewing the rules as causing discriminatory unequal treatment of corporations with German as opposed to foreign shareholders.

In summary, the BFH, with explicit reference to EU law, held that, in substance and indirectly, the German thin capitalization rules were aimed at cross-border thin capitalization involving foreign shareholders, which, in this instance, was a breach of article 25(3) of the Germany-Switzerland Income and Capital Tax Treaty (1971).

As the commentator71 to the case in the International Tax Law Reports noted, the decision of the BFH to apply article 25 to a case of indirect discrimination is inconsistent with the majority opinion in the German treaty literature, which has always supported a strict interpretation of article 24, i.e. as proscribing only direct discrimination.72 In addition, the question of whether or not only direct discrimination, and not covert discrimination, is relevant to article 24 was expressly considered by the Committee on Fiscal Affairs in the

69. Re Shareholder Discrimination by German Thin Capitalisation Rules (2009), at para. 23. 70. Id. 71. J. Luedicke, Re Shareholder discrimination by German thin capitalisation rules : I R 6/09, 13 Intl. Tax L. Repts. 5, p. 646 at p. 648 (2011). 72. K. Vogel, Klaus Vogel on Double Taxation Conventions 3rd ed., margin note 5b (Kluwer L. Intl. 1997), discussing art. 24 and comparing the EU non-discrimination rules and the OECD Model.

29 2008 report,73 which led to the introduction and insertion of paragraph 1 of the Commentary on Article 24 of the OECD Model (2010) as follows:

The non-discrimination provisions of the Article seek to balance the need to prevent unjustified discrimination with the need to take account of these legitimate distinctions. For that reason, the Article should not be unduly extended to cover socalled “indirect” discrimination. (Emphasis added)

The decision in Re Shareholder Discrimination by German Thin Capitalisation Rules to extend the application of article 24 to domestic thin capitalization rules, which were merely indirectly discriminatory, rather than the position agreed by the OECD, can perhaps be rationalized by the fact that the judges in the BFH case were dealing with a tax treaty concluded in 1971. The position of the OECD and, therefore, states concluding tax treaties may not have been clear until the release of the 1986 Report and the eventual changes to the Commentary on Article 24 of the OECD Model (1992) and (2008).

A less charitable view of the approach of the BFH is that the judges may have erred by equating the EU view of non-discrimination with that of the OECD. An analysis of the history of article 24 suggests that the approaches of the European Union and the OECD are fundamentally different and that the OECD has laid out, in article 24, a series of specific detailed provisions that were not meant to generate broad and non-specific principles.74

73. 74.

OECD, supra n. 27, at para. 8. Avery Jones et al., supra n. 6, at sec. 3.

30 The history supports the view that the provisions seek to identify specific cases where discrimination should be prevented:75

[The Article 24 non-discrimination provisions] thus do not lend themselves to a broad interpretation to cover cases of “indirect” discrimination (an obvious allusion to and rejection for the purposes of the OECD Model of the different position on EU non-discrimination rules in the jurisprudence of the European Court of Justice (ECJ)).

So despite the decision in Re Shareholder Discrimination by German Thin Capitalisation Rules, the history and timing of the introduction of the various non-discrimination paragraphs, together with the nature of the OECD Commentary, which is arguably more in the nature of clarification, rather than being of a substantive nature, suggests that “indirect or covert” discrimination is not sufficient to fall within the ambit of article 24(5) of the OECD Model.

6.2.3. The causal relationship or nexus requirement

What exactly is the relationship or nexus required between the foreign ownership requirement of the non-discrimination article and the thin capitalization regime for a tax treaty to override domestic law?

As discussed in section 5., article 24(5) of the OECD Model (2010) envisages an enterprise in one contracting state owned by a resident of the other contracting state. In other words, 75.

Id.

31 the capital of the domestic enterprise must be owned by a non-resident of the enterprise’s state. If the non-discrimination article is to override domestic thin capitalization rules, the question becomes is the cause of the discrimination foreign ownership? The answer to this question is also informative as to whether the type of discrimination dealt with in article 24 is “direct or indirect (covert)” as discussed in section 6.

Two relatively recent cases76 in the United Kingdom concerning the application of article 24(5) in circumstances involving the group loss offset rules, rather than domestic thin capitalization rules, confirmed that the non-discrimination article applies when foreign ownership is the cause of the denial of relief, or the imposition of an additional burden, under the domestic legislation.

In April 2010, the “ownership” paragraph of the non-discrimination article77 was considered by the United Kingdom First-tier Tax Tribunal in FCE Bank plc (2010). This decision was appealed to the Upper Tribunal (Tax and Chancery Chamber) and affirmed by Henderson J and Judge Ghosh QC. The Upper Tribunal (FCE Bank plc (2011)) agreed with the “full and cogently reasoned decision”78 of the First-tier Tax Tribunal, expressly endorsing the principle “that courts give consistent interpretations of treaty provisions contained in the OECD model that are widely used in tax treaties”.79 The judges in the First-tier Tax Tribunal

76. Boake Allen Limited; Bush Boake Allen Enterprises Limited; Bush Boake Allen Holdings UK Limited; Bush Boake Allen Inc; NEC Semi-Conductors Limited; NEC Corporation; Acushnet Limited; Acushnet International Inc; Gallaher Limited NEC Semi-Conductors Limited (2007) and FCE Bank plc (2010) and the subsequent appeal in UK: UTT, 13 Oct. 2011, FCE Bank plc v. Revenue and Customs Commissioners, 14 Intl. Tax L. Repts. 2, p. 319 (2011), Tax Treaty Case Law IBFD. 77. Convention Between the Government of the United Kingdom of Great Britain and Northern Ireland and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and Capital Gains art. 24(5) (31 Dec. 1975), Treaties IBFD was identical to art. 24(5) of the OECD Draft Model (1963). 78. FCE Bank plc (2011), at para. 24. 79. Id., at para. 24.

32 decision were Edward Sadler and John Avery Jones (no less). The facts in the case are relatively simple. The taxpayer, FCE, and another company, FMCL, were UK directly held seventy-five per cent subsidiaries of a US resident parent company. The two UK companies claimed group relief in respect of losses surrendered by FMCL for the accounting period ended 31 December 1994. The UK tax authorities refused on the grounds that FCE and FMCL were not members of the same group during the relevant accounting period, as they did not have a common corporate shareholder resident in the United Kingdom. In all other respects, FCE and FMCL satisfied the requirements to enable trading losses to be surrendered by way of a claim for group relief.

The taxpayer’s specific complaint was that a UK enterprise, which was directly held by a US enterprise, should not be subject to taxation that was more burdensome than the taxation imposed on other UK enterprises that were owned by a UK parent company.

Avery Jones and Sadler JJ defined the approach in FCE Bank plc (2010) as a twofold exercise, i.e.: (1)

is more burdensome taxation imposed on the UK company with a US parent than there would have been if the parent company had been a UK resident? If the answer to that question is yes, then;

(2)

is that difference in taxation based solely on the ground that its capital is “wholly or partly owned or controlled, directly or indirectly” by the US parent company?

As the relevant treaty provision prevented discrimination on the grounds of either direct or indirect US ownership, it was sufficient that there was discrimination on the grounds of

33 direct, though not indirect, ownership. Having examined their own UK authorities, Avery Jones and Sadler JJ were “fortified” in the conclusion that this was a breach of the nondiscrimination article by the decisions of three highest level foreign courts. They referred to the Netherlands Supreme Court (Hoge Raad),80 the Finnish Supreme Administrative Court (Korkein hallinto-oikeus),81 and the Swedish Supreme Administrative Court (Regeringsrätten),82 all of which supported the approach taken in FCE Bank plc (2010). This use of high level foreign court decisions to demonstrate an international consensus on the interpretation of particular treaty provisions is of interest.83 Also of interest are the observations made about the role of the Commentary on Article 24 of the OECD Model in interpreting article 24.84

In summary, applying the reasoning of Avery Jones and Sadler JJ in FCE Bank plc when considering the application of article 24(5) to thin capitalization regimes, it must be 80. NL: HR, 23 Dec. 1992, Decision No. 27.843, BNB 1993/71c, Tax Treaty Case Law IBFD. 81. FI: KHO, 10 May 2005, Decision KHO 10.05.2000/864. 82. SE: RÅ, 1996 ref. 69 and SE: RÅ, 24 Sept. 1998, 4676-1997, 1998 ref. 49, Tax Treaty Case Law IBFD. 83. This implies an obligation to construe tax treaties as part of “a network of international agreements using international language”. In this respect see NZ: CA, 14 June 1990, Commissioner of Inland Revenue v. JFP Energy Inc [1990] 3 NZLR 536 at 538 per Richardson J, Tax Treaty Case Law IBFD, wherein it was suggested that this is important for New Zealand courts as a matter of international tax law. [okay?] As a matter of international law, it has been said that a contracting state (or its court) cannot adopt an interpretation that unreasonably deviates from the prevailing practice of tax treaty concluding nations. This means that a contracting state that makes every effort to establish a common uniform treaty meaning when interpreting a treaty term is acting in good faith (E. Van der Bruggen, Good faith in the Application and Interpretation of Double Taxation Conventions, Brit. Tax Rev. 1, p. 67 (2003). 84. The court in FCE Bank plc (2010) examined the arguments that have been made by the counsel for the UK tax authorities regarding the OECD Model: Commentaries. They noted, first, that caution should be applied in relying on the OECD Commentaries added after the conclusion of a tax treaty, although to the extent to which they represented the current view of members of the OECD, unless an observation is expressed, that may be significant. Second, they commented that para. 77 of the OECD Model: Commentary on Article 24 correctly noted that art. 24(5) relates only to the taxation of the enterprise concerned and not of the persons owning its capital. They question the logic of the statements that follow, i.e. “that it cannot be interpreted to extend benefits of rules that take account of the relationship between a resident enterprise and other resident enterprises (e.g. rules that allow consolidation, transfer of losses or tax-free transfer of property between companies under common ownership)”. Avery Jones and Sadler JJ think that those relationships referred to were not related to the owner, but, rather, simply to the enterprise under consideration. In any event, this was a wholly different situation, involving grouping of profits and losses between domestic subsidiaries of the non-resident parent company, and as it was not referred to in the OECD Commentary, which suggests that it was not a concern for countries in the OECD.

34 established that foreign ownership of the enterprise is the cause for the application of the thin capitalization rules for the non-discrimination article to apply. It does not matter that foreign ownership is just one of the reasons for the application of the rules if the rules operate on the basis that it is an essential condition. In their article, Avery Jones et al. (2011) give an example of a thin capitalization regime that has multiple conditions, one of which is the critical non-resident ownership requirement. Avery Jones et al. (2011) conclude that such a regime would be in breach of the non-discrimination article because of the existence of a condition of foreign ownership that is essential to the application of the rules.85 If, however, the thin capitalization rules applied and they were indifferent to whether or not non-resident ownership was present, article 24(5) would have no application.

This causal relationship can also be viewed from the perspective of categorizing the discrimination as either a form of indirect or direct discrimination. Viewed in this way, as the cause of the application of the thin capitalization rules is foreign ownership, this is an example of the UK courts requiring a very direct type of discrimination before applying article 24.

6.2.4. Is the broad wording of article 24(5) to be read as consistent with articles 9(1) or 11(6)?

As discussed in section 5., the Commentary on Article 24 of the OECD Model (2010) insists that the principle in article 24(5) is too broad and must be constrained by the more specific exceptions contained in article 24(4), which permit non-discrimination in circumstances 85.

Avery Jones et al., supra n. 6, at sec. 4.3.6.

35 where the domestic rules are compatible with articles 9(1) or 11(6).86 The courts, however, have provided little guidance to date on whether or not these exceptions should be imported into article 24(5).

In part, this is due to a reluctance to apply the Commentary on Article 24 of the OECD Model (2008) to situations that are being litigated that involve tax treaties concluded prior to 2008, and, in many cases, long before 2008. Given that the vast majority of tax treaties were concluded prior to 2008, this is not an uncommon issue. In cases involving article 24(5), decisions of the BFH87 and the French Supreme Court (Conseil d’Etat)88 have taken the view that the OECD Commentary simply should not be referred to in circumstances in which the tax treaty concerned predates the OECD Commentary.

The BFH in Re-Treaty Discrimination and Fiscal Unity (2011) considered the application of article 24(5) in circusmtnaces where a non-resident parent company could form a fiscal unity with its German-resident subsidiary. The BFH, in considering the Germany-United Kingdom Income and Capital Tax Treaty (1964)89 described the OECD Commentary on Article 24 (2008) as “irrelevant” saying “it cannot be inferred from the wording of the convention or from the context of the convention, that the provisions governing taxation as a group and

86. Para. 79 OECD Model: Commentary on Article 24 (2010) and see also OECD, supra n. 27, at para. 88. 87. Re-Treaty Discrimination and Fiscal Unity (2011), regarding the application of para. 77 of the OECD Model: Commentary on Article 24 (2008) in a case concerning art. 24(5) and fiscal unity with companies. 88. Re Société Andritz Sprout Bauer (2003), regarding the application of para. 79 of the OECD Model: Commentary on Article 24 (2008) in a case concerning the application of the French thin capitalization rules to an Austrian owned French company. 89. Convention Between the United Kingdom of Great Britain and Northern Ireland and the Federal Republic of Germany for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion (26 Nov. 1964) (as amended through 1970), Treaties IBFD.

36 the consolidation of corporate groups should be a priori excluded from the scope of protection of article 24 (5)...”.90

In Re Société Andritz Sprout Bauer (2003), the French Supreme Court considered a case involving the Austria-France Income, Capital and Inheritance Tax Treaty (1959)91 and the application of the French thin capitalization provisions to a French subsidiary of an Austrian parent. The Supreme Court applied the equivalent to article 24(5) in determining that the French thin capitalization rules were discriminatory on the basis that had the French subsidiary been owned by a French parent, rather than an Austrian parent, the thin capitalization rules would not have applied. The Court simply would not listen to arguments based on the OECD Commentary relating to arm’s-length principles (article 9(1) of the OECD Model) “since those Commentaries are subsequent to the adoption of the provisions at issue”.92

This approach of the German and French tax courts reflects the view held by many influential commentators that the relevant OECD Commentary that a court should have reference to is the one in the minds of the negotiators at the time the relevant tax treaty was concluded and not the subsequent OECD Commentary. This, of course, makes reference to a later OECD Commentary significantly less influential as indicated by Lang and Brugger (2003):93

90. Re-Treaty Discrimination and Fiscal Unity (2011), at p. 867 (unofficial translation). 91. Convention Between the Republic of Austria and the French Republic for the Avoidance of Double Taxation and the Provision of Mutual Assistance with respect to Taxes on Income and Capital as well as Succession Duties [unofficial translation] (8 Nov. 1959), Treaties IBFD. 92. Re Société Andritz Sprout Bauer (2003), at p. 638. 93. M. Lang & F. Brugger, The role of the OECD Commentary in Tax Treaty interpretation, 23 Austrl. Tax Forum p. 107 (2008). See also Vogel, supra n. 24, where that author stated: “As there is no other way under the Vienna Convention, however, to establish a decisive role in the Commentaries in interpreting tax treaties, it

37

Later Commentary amendments cannot serve to establish the parties’ intentions upon conclusion of a double tax convention. Such amendments may only play a limited role in the interpretation of previously concluded double tax conventions if recourse to other means of interpretation remains inconclusive.

Other scholars support a more ambulatory use of the Commentary.94 These scholars suggest that such an approach is more pragmatic given the frequent changes to the OECD Commentary and, indeed, to tax treaties themselves. Given the process of treaty negotiation, where a typical tax treaty might take two years to negotiate, but some may take more than a decade, negotiators are aware of and utilize OECD positions that may not yet be public. The OECD Commentary also reflects an international organization’s view that is officially approved by the governments of OECD Member countries and not the view of any one particular tax administration that may be a party to the particular dispute. So a court does not fail to interpret a tax treaty fairly if it refers to the OECD Commentary.95 In addition, it is said that later changes to the OECD Commentary do not have the constitutional authority that would bless a particular tax treaty approved by a parliament in the light of its intended interpretation given by the existing OECD Commentary. In fact, the

follows that changes in the Commentaries after the conclusion of the tax treaty can neither amend the treaty, as was shown before, nor retroactively determine its interpretation.” and G. Hill, The Interpretation of Double Taxation Agreements-the Australian experience, 57 Bull. Intl. Fiscal Documentation 8, sec. 4.1. (2003), Journals IBFD, where that author stated: “But it would seem a difficult matter, absent any consensus of the contracting states, to regard commentary after ratification in the same way as a commentary before, if only because the changed commentary was not taken into account by the parties to the Treaty when adopting the particular provision”. 94. R. Vann, Interpretation of tax treaties in New Holland, in A Tax Globalist: The Search for the Borders of International Taxation: Essays in Honour of Maarten J. Ellis sec. 5. (H. van Arendonk, F. Engelen & S. Jansen eds., IBFD 2005), Online Books IBFD and F. Engelen, Interpretation of Tax Treaties under International Law sec. 10.9. (IBFD 2004), Online Books IBFD. 95. J.F. Avery Jones, The Effects of Changes in the OECD Commentaries after a Treaty is Concluded, 56 Bull. Intl. Fiscal Documentation 3, sec. 1. (2002), Journals IBFD.

38 courts frequently interpret domestic legislation in the light of changed circumstances, taking into account such things as new inventions and, to this end, if the OECD Commentary represents a consensus on how developments are to be treated, as in the case of crossborder software payments, this is neither undesirable nor problematic.96

First, the OECD Commentary is simply an aid to interpretation, sometimes having little or no influence and the general rule of interpretation is still to focus on the text of a tax treaty itself because of article 31 of the Vienna Convention (1969), thereby requiring a later OECD Commentary to represent a fair interpretation of the text of the OECD Model.97 But there is no rule that anything that happens after a tax treaty is concluded is irrelevant98 or inadmissible.

Second, as evidenced by the Canadian Federal Court of Appeal in Prevost Car Inc (2009),99 it is the nature of the revision to the OECD Commentary that is the question that the court

96. Id., at sec. 2.1. It should be noted that a court tries to interpret a tax treaty and that the OECD Commentaries, particularly subsequent OECD Commentaries, may have limited, if any, value to achieve that end. It is quite a different question as to whether an OECD Commentary would override the clear terms of a tax treaty, which is something that would never be acceptable. Even a competent authority agreement that might bind the governments internationally may not affect the taxpayer, unless it had gone through a constitutional process for enactment as legislation. In this respect, see DE: BFH, 2 Sept. 2009, IR 90/08, Re a German-Belgian Competent Authority Agreement; Finanzamt v. AA (an individual), 12 Intl. Tax L. Repts. 4, p. 475 (2010), Tax Treaty Case Law IBFD. 97. D. Ward, Is there an Obligation in International Law of OECD Member Countries to follow the Commentaries on the Model?, in The Legal Status of the OECD Commentaries p. 86 (S. Douma & F. Engelen eds., IBFD 2008), Online Books IBFD. 98. Avery Jones, supra n. 95, at sec. 2.1. 99. CA: FCA, 26 Feb. 2009, Prevost Car Inc v. Canada 209 FCA 57, [2010] 2 FCR 65, 2009 DTC 5053 at para. 12 per Decary JA on behalf of himself, Blais, and Sharlow JJA, Tax Treaty Case Law IBFD: “[10] The worldwide recognition of the provisions of the Model Convention and their incorporation into a majority of bilateral conventions have made the Commentaries on the provisions of the OECD Model Convention a widely-accepted guide to the interpretation and application of the provisions of existing bilateral conventions… [11] The same may be said with respect to later Commentaries, when they represent a fair interpretation of the words of the Model Convention and do not conflict with Commentaries in existence at the time a specific treaty was entered and when, of course, neither treaty partner had registered an objection to the new Commentaries. ...

39 should be concerned with. If the revision involves a fundamental change, the revised OECD Commentary would have little application to a concluded tax treaty, but this would not be true if the revision were more in the nature of a clarification.100

It can be argued that the type of change made to the Commentary on Article 24 of the OECD Model (2008) may fall into the category of being complementary in that it elicits, rather than contradicts, views previously expressed. It is quite clear that OECD Committee members were aware of the problem in 1986 when the 1986 Report was produced and this very issue was highlighted.101 It should also be noted that the Committee, in its discussions, made it clear that the changes to the OECD Commentary on Article 24 (2008) were designed to “clarify” the position and that, at least from 1992 (if not from 1986), the Committee’s consensus view was relatively well-established.102

In the author’s view, the approach of the BFH103 and the French Supreme Court104 is appropriate for tax treaties concluded in 1964 (subject to the protocol of 30 October 1970) and 1959 respectively. It is, however, questionable with regard to a tax treaty negotiated after 1986 (or perhaps 1992). The wording of article 24(5) is simply too broad to be interpreted without the context indicated in the 1986 Report, which was subsequently expressed in the Commentary on Article 24 of the OECD Model (1992) onwards.

[12]

I therefore reach the conclusion, that for the purposes of interpreting the Tax Treaty, the OECD Conduit Companies Report (in 1986) as well as the OECD 2003 amendments to the 1977 Commentary are a helpful complement to the earlier Commentaries, in so far as they are eliciting, rather than contradicting, views previously expressed. ...” 100. H. Ault, The Role of the OECD Commentaries in the Interpretation of Tax Treaties, 22 Intertax 4, pp. 144-148 (1994) and P.J. Wattel & O. Marres, The Legal Status of the OECD Commentary and Static or Ambulatory Interpretation of Tax Treaties, 43 Eur. Taxn. 7, sec. 2.4.9. (2003), Journals IBFD. 101. OECD, supra n. 4, at paras. 46 and 66(b). 102. OECD, supra n. 27, at para. 88. 103. Re Treaty Discrimination and Fiscal Unity (2011). 104. Re Société Andritz Sprout Bauer (2003).

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7. Conclusions

7.1. Introductory remarks

After reviewing the OECD Reports and the Commentary on Article 24 of the OECD Model, the court decisions concerning article 24(5) and domestic legislation, i.e. loss grouping of fiscal unity and thin capitalization, the author suggests that there are three universal principles in respect of the relationship between the non-discrimination article (article 24(5)) and domestic thin capitalization rules. These are set out in sections 7.2., 7.3. and 7.4.

7.2. An implied arm’s-length principle derived from article 24(4) and the Commentary on Article 24 of the OECD Model

First, from 1986 in respect of OECD Reports or 1992 in respect of the Commentary on Article 24 of the OECD Model, there is a common OECD understanding that, when a domestic thin capitalization rule enforces an arm’s-length principle, the literal wording of article 24(5) of the OECD Model, which prevents a state from discriminating against an enterprise that is owned or controlled by residents of the other state, should be read down. Effectively, this means that domestic thin capitalization rules override article 24(5), provided that these are consistent with the arm’s-length principles in articles 9(1), 11(6) and 12(4).

Thin capitalization rules can operate to prevent the conversion of an arm’s-length profit by the borrowing entity into an excessive claim for interest expense. The non-discrimination

41 article does not interfere with thin capitalization rules, unless those rules disallow interest expense beyond a level that is consistent with an arm’s-length profit.

The corollary is that when the domestic thin capitalization rules go too far and are not predicated on an arm’s-length basis, a particular risk for those rules that are based on a fixed ratio, the non-discrimination article should override the domestic thin capitalization regime.105 As discussed in section 5., the OECD is concerned that, where a fixed ratio is low and rigidly imposed, there is a risk of tax protectionism offensive to the non-discrimination article.

7.3. A more literal reading of the non-discrimination article for earlier tax treaties

Second, with regard to tax treaties concluded prior to the dates referred to in section 7.2. there is a strong argument, based on the history of the OECD Commentary and Reports and case law from Germany106 and France,107 that the literal words of article 24(5) apply and are not subject to any arm’s-length exemption imported from the exception in article 24(4). This argument may be strengthened by the subsequent practice of a tax administration in the negotiation of tax treaties that expressly exclude thin capitalization rules from the ambit of the non-discrimination article.

7.4. Requirement for foreign ownership and non-application to indirect discrimination

105. Examples of this approach are ES: TS, 7 Dec. 2011, Decision No. 451/2008; Appeal No. 5871/2006 (2011) and Appeal No. 3196/2007 (2011). 106. Re-Treaty Discrimination and Fiscal Unity (2011). 107. Re Société Andritz Sprout Bauer (2003).

42 Third, albeit subject to the first principle, in considering the application of article 24(5) of the OECD Model the UK decisions108 confirm the need for a causal relationship between the foreign ownership of the enterprise and the application of the thin capitalization rules. If foreign ownership is an essential condition of a thin capitalization regime it is arguable that the regime is in breach of the non-discrimination article. Based on these UK decisions and the OECD Commentary, the better view is that the non-discrimination article in the OECD Model operates only in respect of overt and not covert discrimination.

The application of the non-discrimination article to domestic regimes, particularly involving thin capitalization when the regime applies due to foreign ownership or control, is complex because article 24(5) cannot be interpreted on its face. Understanding the three principles above is essential to the interpretation of the non-discrimination article.

This leads to the conclusion that in this area of tax law it is likely that taxpayers and tax administrators will continue to litigate, or attempt to avoid litigation through the design of thin capitalization regimes and their approach to treaty negotiation. In short, there is much unfinished business in regard to the relationship between the non-discrimination article and foreign ownership thin capitalization rules.

108. FCE Bank plc v. Revenue and Customs Commissioners (2010) and Boake Allen Limited; Bush Boake Allen Enterprises Limited; Bush Boake Allen Holdings UK Limited; Bush Boake Allen Inc; NEC SemiConductors Limited; NEC Corporation; Acushnet Limited; Acushnet International Inc; Gallaher Limited NEC Semi-Conductors Limited (2007).