Tax Challenges Arising from the Digitalisation of the Economy – Subject to Tax Rule (Pillar Two)

II. Elimination of Double Taxation

Article 23 A

5. The provisions of paragraph 1 shall not apply to income derived by a resident of a Contracting State which may be taxed in the other Contracting State only in accordance with the provisions of Article [STTR].

6. The provisions of paragraph 2 shall not apply to tax paid by a resident of a Contracting State in the other Contracting State in accordance with the provisions of Article [STTR].

Article 23 B

3. The provisions of paragraph 1 shall not apply to tax paid by a resident of a Contracting State in the other Contracting State in accordance with the provisions of Article [STTR].

1. Introduction

1. The STTR restores to the source State a limited taxing right, or in some cases supplements an existing limited taxing right retained by the source State, and operates as a derogation from the other provisions of the Convention that would otherwise restrict the source State’s right to tax. This creates an interaction between the STTR and the elimination of double taxation provisions contained in tax treaties.

2. For example, under paragraph 1 of Article 23 A of the OECD Model, the residence State is obliged to exempt an item of income where the source State is permitted to tax that item of income in accordance with the treaty. Where the conditions are met for the STTR to apply, the source State will be permitted, in accordance with the treaty, to apply additional tax and the residence State will then be obliged under the provisions of the elimination article to exempt that income from tax. Even where that obligation is not taken into account for the purposes of determining the adjusted nominal rate, and therefore does not increase the additional tax that can be applied in the source State, the residence State will nevertheless be deprived of its taxing right. The result of this will be that only the source State will tax the affected payment; and only at the specified rate.

3. Similar considerations arise where the residence State is obliged to provide a credit under paragraph 1 of Article 23 B or paragraph 2 of Article 23 A of the OECD Model. Even though that credit is not taken into account in computing the adjusted nominal rate for the purposes of the STTR (according to subdivision (i) of subparagraph b) of paragraph 6), the residence State’s taxing right is reduced by the credit it is obliged to give for the additional tax applied in the source State.

4. These considerations are relevant where the application of the STTR would result in a new or greater obligation being imposed on the residence State under provisions based on Article 23 A or 23 B.

5. As a general rule, the approach taken in this report preserves the position that would have applied before the STTR comes into play and makes adjustments to the operation of the treaty elimination provisions in respect of an additional obligation that would otherwise be imposed on the residence State as a result of the source State taxing covered income at the specified rate. This avoids an unintended reallocation of taxing rights away from the residence State.

6. This approach sets limits on the obligations imposed on the residence State under the elimination of double taxation provisions of treaties based on the Convention, but it does not govern or disturb other mechanisms that may apply outside the treaty to mitigate or eliminate double taxation. For example, a residence State may, under its domestic law, provide unilateral credit relief for the additional tax imposed as a result of the source State taxing covered income at the specified rate under the STTR, or it may provide relief for the tax paid to the source State by way of a deduction.

7. Neither does the approach taken in this report regulate or alter the treatment, for the purposes of applying the IIR and UTPR, of tax paid as a result of the operation of the STTR. Tax paid as a result of the operation of the STTR is, as a tax in lieu of generally applicable income tax, a covered tax for the purposes of the IIR and UTPR; and is allocated and accounted for in the ETR computation required under the GloBE rules.

8. Therefore, the only adjustments made to Articles 23 A and 23 B are to add a sentence that would disapply the exemption method in cases where it would not have applied in the absence of the STTR, and a sentence that would disallow a foreign tax credit for the tax paid under the STTR. These outcomes permit the source State to apply tax at the specified rate in accordance with the STTR, without this resulting in a reallocation of taxing rights away from the residence State that would arise solely as a result of the operation of the STTR. Given that the STTR only applies where covered income is subject to a rate of tax below 9% in the residence State, applied to a measure of net income, and that the STTR results in the source State being permitted to tax the gross amount of the covered income up to the specified rate, the residence State’s capacity to provide additional relief may in many cases already be limited or exhausted.

2. Exemption method

9. The STTR only applies in situations where the tax rate in the State of residence is below the agreed minimum rate of 9% and, under the other provisions of the Convention, the covered income either cannot be taxed in the State of source, or that State’s taxing right is limited to a rate below the specified rate (see paragraph 3 of the STTR). The modifications to Article 23 A are intended to preserve the position that would have applied before the operation of the STTR in both of these scenarios.

2.1. No original source taxation in accordance with the treaty

10. In the scenario where income cannot be taxed in the State of source in the absence of the STTR, there is no obligation on the residence State to provide exemption under Article 23 A. But where the STTR applies, the source State would be permitted to tax in accordance with the Convention, which would then give rise to an obligation on the residence State to exempt the whole of the income. This obligation arises solely because the STTR applies. A new provision is therefore needed to deactivate the application of the exemption method in this scenario, preserving the position before the application of the STTR. Obliging the residence State to provide an exemption in this scenario would result in that State losing any taxing right it would be exercising before the application of the STTR. This goes beyond the intended effect of the STTR, which is not to reallocate taxing rights but to permit the source State to apply tax capped at the specified rate to income subject to low nominal rates of tax in the residence State.

11. For example, a resident of a Contracting State derives income from the rental of movable property used in the other Contracting State, which is not attributable to a permanent establishment in that other State. In this case, absent the STTR, the other Contracting State cannot tax such income in accordance with Article 7. The residence State (the first-mentioned State) would not therefore provide an exemption in accordance with Article 23 A, because the income cannot be taxed in the source State (the other State). Assume the treaty has an STTR and this income is covered income; if the STTR is triggered, the source State will have a taxing right in accordance with the Convention and, therefore, the residence State would be required to provide an exemption under Article 23 A. However, given that approach taken is to preserve the original outcome, then a special provision is needed to deactivate the exemption under paragraph 1 of Article 23 A.

12. Therefore, paragraph 5 of Article 23 A regulates the interaction between the STTR and the exemption method. Paragraph 5 deactivates the application of the exemption method under paragraph 1 where the source State can tax in accordance with the Convention only because the STTR applies. This ensures that, in the scenario outlined above, the original outcome (no exemption in the residence State) is preserved regardless of the application of the STTR.

2.2. Original limited source taxation in accordance with the treaty

13. Under the OECD Model Tax Convention the only items of income over which the source State has limited taxing rights are dividends and interest under Articles 10 and 11. The elimination of double taxation in respect of these items of income is not governed by paragraph 1 of Article 23 A, because that paragraph is subject to the provisions of paragraph 2. Under paragraph 2, the exemption method is disapplied and the credit method is substituted. The requirement under paragraph 2 of Article 23 A for the application of the credit method (“…which may be taxed in the other Contracting State in accordance with the provisions of Articles 10 and 11…”) is therefore still met. It follows that no adjustments are needed to deal with this interaction and the credit method continues to apply with respect to these items of income. Paragraph 5 has no effect on this treatment, but paragraph 6 is brought into play, the effect of which is discussed under the credit method below.

14. However, the provisions of bilateral treaties may allow limited source taxation of other categories of income and may not include those categories in provisions based on paragraph 2 of Article 23 A. In that scenario, the residence State will have an obligation to provide exemption under paragraph 1 of Article 23 A, regardless of whether the STTR applies. In order to preserve this existing treatment, it is important that paragraph 5 does not disapply paragraph 1. This is achieved by the limitation in paragraph 5, which restricts its application to cases where the “only” reason the source State is permitted to tax in accordance with the Convention is that the STTR applies. Where there is a pre-existing source State taxing right under another provision of the Convention, this condition is not met and paragraph 5 has no effect. This preserves the position that would have applied before the STTR comes into play.

15. The principles outlined under both subheadings above can be illustrated by the following examples.

2.2.1. Example 1 – no original source State taxing right

16. SCo, a resident of State S, pays 100 of covered income to RCo, a company resident in State R. In State R, RCo benefits from a preferential adjustment in respect of the item of covered income that reduces the State R tax rate on the income to 4%. States S and R have a treaty which does not allow State S to tax the 100 of covered income, but includes the STTR with the agreed minimum rate of 9%. The 100 of covered income is within the scope of the STTR and the specified rate computed in accordance with paragraph 2 of the STTR is 5% (9% - 4%). The total tax that State S can apply in accordance with the S-R treaty is therefore 5 (5% on 100). The only reason that State S can tax in accordance with the treaty is that the STTR applies. Paragraph 5 of Article 23 A disapplies paragraph 1 and State R is not obliged to exempt the income.

2.2.2. Example 2 – limited original source State taxing right

17. The facts are the same as example 1, except that under the terms of the S‑R treaty the article governing this item of covered income generally permits the source State to tax it at 2.5%. State R has adopted the exemption method in the S‑R treaty and this category of covered income is not included in a provision based on paragraph 2 of Article 23 A. The 100 of covered income is within the scope of the STTR and the specified rate computed in accordance with paragraph 2 of the STTR is 5% (9% - 4%). Another article of the S-R treaty permits the 100 of covered income to be taxed at 2.5%. This is preserved by the second sentence of paragraph 3 of the STTR. State S is also permitted to apply tax at the specified rate, which the second sentence of paragraph 3 of the STTR reduces to 2.5% (5% - 2.5%). The total tax that State S can apply in accordance with the S-R treaty is 5 (2.5% + 2.5% on 100). If the STTR had not applied, State R would have exempted the whole 100 in accordance with paragraph 1 of Article 23 A. Although the STTR applies, it is not the “only” reason that State S can tax the covered income in accordance with the treaty. Paragraph 5 of Article 23 A does not therefore apply and State R will continue to exempt the income in accordance with paragraph 1 of Article 23 A.

3. Credit method

18. Paragraphs 6 of Article 23 A and 3 of Article 23 B deal with the interaction between the STTR and the credit method. The principle reflected in this paragraph is that no credit should be given in the residence State for the tax paid in the source State in accordance with the STTR. As with the exemption method, the approach taken preserves the position that would have applied before the STTR comes into play. Therefore, the residence State will continue to provide a deduction from tax as if the STTR was not applied.

19. The STTR supplements other provisions of the Convention that allow limited source taxation. Thus, these other provisions continue to apply as well as the provisions in Articles 23 A and 23 B, that require the residence State to provide a credit for the tax paid in the source State. This ensures that the outcome is not modified by the inclusion of a STTR.

20. Paragraph 6 of Article 23 A and paragraph 3 of Article 23 B disallow a credit for any additional tax paid in the source State in accordance with the STTR. This will preserve the position that would have been applied with respect to the credit method in the absence of an STTR.

21. For example, a resident of State S makes a payment of covered income of 100 to a company that is a resident of State R. The R-S treaty includes an article generally permitting the source State to tax this category of income at a rate of 2.5% and includes an STTR with the agreed minimum rate of 9%. State R has a tax rate of 4% in accordance with paragraphs 5 and 6 of the STTR. In the absence of an STTR, the tax paid in State S would have been 2.5. State R would have been required to give a credit of up to 2.5 against its own tax on the covered income.

22. The specified rate in accordance with the STTR is 5% (9% - 4%). However, the tax paid under the STTR cannot exceed 2.5% (5% specified rate - 2.5% existing rate) in accordance with the second sentence of paragraph 3 of the STTR. In this case, State S would tax the interest payment at 5% (2.5% original source right + 2.5% under the STTR). State R would continue to provide a credit for the tax paid in State S with respect to the original 2.5%, but would not be required under the treaty to give a credit for the tax paid in State S with respect to the additional 2.5%, which is the outcome that would have obtained before the application of the STTR.

23. States providing unilateral relief by way of credit under their domestic taxation laws may wish to consider aligning the domestic law and treaty outcomes where the STTR applies.