Bulletin source versus residence - jfb and rts

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International / OECDA Change of Paradigm in International Tax Law: Article 7 of Tax Treaties and theNeed To Resolve the Source versus Residence DichotomyJoão Francisco Bianco[*]

and Ramon Tomazela Santos[**]

Issue: Bulletin for International Taxation, 2016 (Volume 70), No. 3Published online: 24 February 2016

The authors, in this article, consider the problem of, and the potential solution to, the need to resolve thedichotomy between source and residence taxation with regard to international taxation and tax treaties.

1. IntroductionThis article seeks to highlight the change in the attitude and mindset of some developed and developing countriestowards the interpretation of article 7 of tax treaties based on the OECD Income and Capital Model Convention (2014).[1]

This issue lies at the core of the debate on the allocation of taxing rights between the source state and the residencestate.

On the one hand, developed countries, especially in the European Union, have started to claim the right to tax at leasta portion of profits obtained by US multinational enterprises (MNEs), such as Amazon, Apple, Google and Starbucks,from the exploitation of their consumer market, even without the characterization of a permanent establishment (PE) intheir territory. The latest example of this change in the behaviour of developed countries is the “diverted profits tax” (DPT)introduced by the United Kingdom to ensure the taxation of profits generated in its territory, when the taxpayer avoidscharacterization as a PE.

On the other hand, developing countries argue that the remuneration derived from technical services should be taxed bythe source state to prevent the erosion of domestic tax bases through payments made to non-resident companies. Thecontroversy on the taxation of technical services by the source state received a new impetus with the recent inclusion ofa specific distributive rule in the UN Model (2011),[2] which is designed to permit the levying of income tax on the price ofservices provided by non-resident companies, regardless of characterization as a PE.

At the end of this article, the authors note the need to resolve the current paradigm that governs international taxation,as the dichotomy between source and residence in the allocation of taxing rights has not kept up with the expansionof international trade, the expansion of the service sector, the constant development in information technology (IT), thegrowing importance of new factors of production and the recent advances in the area of electronic (e-)commerce. All ofthese factors have significantly changed the business models of MNEs operating worldwide.

2. Article 7 and the Structure of Tax TreatiesTax treaties contain a schedular structure, whereby different types of income are listed in specific distributive rules thatassign the right to tax, on a cumulative or exclusive basis, to the two contracting states. This is based on connectingfactors that were taken into account in the course of a historical process initiated in the 1920s, which began with acompromise solution[3] between the member countries of the League of Nations.[4]

* Master of Laws and PhD in tax law, University of São Paulo (USP), and Director of the Brazilian Institute of Tax Law (IBDT), Member ofthe Board of Directors of the International Association of Tax Judges, Former Judge of the Administrative Court of Tax Appeals (CARF)and Visiting Professor in post-graduate courses in Brazil. The author can be contacted at [email protected].

** Master of Laws (LLM) in international taxation, Vienna University of Economics and Business (Wirtschaftsuniversität Wien, WU) andMaster of Laws candidate in tax law, University of São Paulo (USP), and Member of the Brazilian Institute of Tax Law (IBDT) and VisitingProfessor in post-graduate courses in Brazil. The author can be contacted at [email protected].

1. Most recently, OECD Model Tax Convention on Income and on Capital (26 July 2014), Models IBFD.2. Most recently, UN Model Tax Convention on Income and on Capital (1 Jan. 2011), Models IBFD.3. P. Brandstetter, Taxes Covered – A Study of Article 2 of the OECD Model Tax Conventions sec. 3.2.1.1. (IBFD 2011), Online Books IBFD.4. K. Vogel, The Schedular Structure of Tax Treaties, 56 Bull. Intl. Fiscal Docn. 6 (2002), Journals IBFD.

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In the early stages of development of the League of Nations Models, which served as the basis for the OECD Model,[5]

most countries had schedular income tax systems, in contrast to the current comprehensive income tax systems.[6] In the1923 report, prepared by the four economists Edwin Seligman, Josiah Stamp, Gijsbert Bruins and Luigi Einaudi, for theLeague of Nations, it was noted that, at that time, only Germany, the Netherlands, the United Kingdom and the UnitedStates had introduced comprehensive personal income tax regimes into their tax systems. The remaining countries werestill charging specific taxes on certain types of income, such as taxes on land and business profits, among others.[7]

Consequently, as even the domestic tax systems existing at that time separated income into categories for tax purposes,the League of Nations Models retained this method of income segregation, i.e. the “basket approach”.[8] This is, currently,a challenge to the correct classification[9] of income in tax treaties.[10]

A schedular structure presupposes that the classification of income derived from international transactions is containedin one of the distributive rules of a tax treaty. As a result, following the fulfilment of the conditions for treaty entitlement,i.e. subjective scope (persons covered) and objective scope (taxes covered), income should be classified into one ofthe distributive rules for the purposes of allocating the right to tax it between the contracting states.[11] To this end, VanRaad (2008) asserts that the process of classification of certain income into the distributive rules of a tax treaty should becarried out in stages, based on the following logic: (i) classification of the income in one of the specific distributive rules,i.e. articles 6, 8, 10, 11, 12, 16, 17, 18 or 19; (ii) classification of the income in one of the general distributive rules, i.e.articles 7, 13, 14 or 15; and (iii) classification of the income in the residual distributive rules, i.e. article 21 or 22.[12]

In this scenario, it is clear that a key role is played by article 7 of the OECD Model (on which Brazil has based all of thetax treaties that it has concluded), whereby the residence state has the exclusive right to tax the profits obtained by anenterprise through the development of economic activities abroad, except when a PE can be characterized in the sourcestate, the profits in respect of which may be taxed by the source state, i.e.:

[p]rofits of an enterprise of a Contracting States shall be taxable only in that State unless the enterprise carries onbusiness in the other Contracting State through a permanent establishment situated therein. If the enterprise carrieson business as aforesaid, the profits that are attributable to the permanent establishment in accordance with theprovisions of paragraph 2 may be taxed in that other State.

As can be seen, article 7 of the OECD Model states that profits arising from the exercise of a business activity should betaxed exclusively in the residence state. The only exceptions to this general rule rely on the economic activity performedin the source state being undertaken by way of a PE, as well as on the income being classified into specific distributiverules, which establish a specific allocation of the right to tax.

In this context, it should be noted that article 7 of the OECD Model refers to the exercise of any economic activity carriedout by the resident of a contracting state, regardless of whether it involves the sale of goods, the provision of services orany other business activity. The term “resident” also encompasses any person liable to tax in the residence state, beingeither a legal entity or an individual. Its scope is not restricted to companies organized in a corporate form.[13]

5. J. Sasseville, The OECD Model Convention and Commentaries, in Multilingual Texts and Interpretation of Tax Treaties and EC Tax Law sec. 7.1.(G. Maisto ed. IBFD 2005).

6. Brandstetter, supra n. 3.7. J.F. Avery Jones et al., The Origins of Concepts and Expressions used in the OECD Model and their Adoption by States, Brit. Tax Rev. 6, p. 731

(2006).8. Id., at p. 733, where it is stated that “... the categories of income in the Model today are a surviving remnant of impersonal taxes existing at the time

of the 1927 OECD Model applied to income taxes. Capital gains are a later addition”.9. In this article, the term “qualification” is used in its strict sense to describe the situation in which a contracting state defines the distributive rule of the

tax treaty applicable to an item of income based on its domestic law, either by general reference to domestic law, i.e. in article 3(2), or by specificreference to domestic law. The term “classification” is used in all other situations that do not involve the use of domestic laws of a contracting state,but base the interpretation of the facts on the terms used in the tax treaty. For more on this, see S.L. Boix, Conflicts of Qualification ConcerningPartnerships with Special Reference to the OECD Partnership Report, in Fundamental Issues and Practical Problems in Tax Treaty Interpretationp. 443 (M. Schilcher & P. Weninger eds., Linde 2008).

10. Brandstetter, supra n. 3.11. M. Lang, General Report, in Double non-taxation sec. 2.1.2. (IFA Cahiers vol. 89a, 2004), Online Books IBFD.12. K. van Raad, Escopo geográfico das regras de distribuição da convenção modelo da OCDE, 22 Revista Direito Tributário Atual, pp. 101-107 (2008).13. For more information, see J.F. Bianco, Os lucros das empresas e o art. 7º dos tratados contra a dupla tributação, in Estudos Avançados de Direito

Tributário pp. 129-143 (R. Vasconcellos et al. eds., Elsevier 2012).


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It is, therefore, clear that article 7 of the OECD Model has a universal scope in serving as an “umbrella” for differenttypes of income derived from business activities, as it covers the results arising from the exercise of an economic activityconducted by a resident of a contracting state, i.e. the residence state, in the other contracting state, i.e. the source state,provided that the relevant income is not expressly included in one of specific distributive rules.[14] Article 7 of the OECDModel can be considered to be the heart of a tax treaty as under this article the largest portion of income derived frominternational economic activities is classified.[15]

The distribution of taxing rights based on specific distributive rules takes precedence over the general concept ofbusiness profits. Consequently, if an item of income that composes the profit is subject to a special treatment underthe tax treaty, there is no doubt that the specific distributive rule should prevail. However, in the absence of a specificdistributive rule for a particular item of income, this amount must be classified under article 7 of the tax treaty, providedthat its economic substrate integrates the general concept of business profits.[16]

Based on this, it is clear that article 7 of the OECD Model lies at the centre of the conflict between source and residence.This is because the first part allocates the right to tax the business profits exclusively to the residence state, while thesecond part grants to the source state the right to tax the profits attributable to a PE located in its jurisdiction.

There is no universally accepted criterion for the allocation of tax jurisdiction between the source state and the residencestate.[17] What has been recognized from the early stages of development of international tax law is the need for abalanced and equitable distribution of the income generated in international transactions between the states involved,which provide the infrastructure and environment for the taxpayer to earn the income.

However, a balanced and equitable distribution of the income between the states involved, which would be implementedby way of the distributive rules of a tax treaty, is ultimately only theoretical, as being a great ideal derived from inter-national equity. In practice, the historic evolution of the international tax law demonstrates that the developed countriesthat joined the League of Nations and later the OECD made efforts to concentrate the right to tax in the residence stateto the greatest possible extent, thereby giving priority to capital exporting countries. In order to support this, developedcountries argued that the source of income, from an economic perspective, should be attributed to the jurisdiction in whichthe production factors that allowed the generation of revenues were located.

Under this approach, the demand side, which reflects the consumer market in which products and services are sold,was relegated to a secondary place. In the view of developed countries, for the purpose of elaborating clear, simple,predictable and practical distributive rules, the right to tax could only be attributable to the source state if a sufficientdegree of participation of the taxpayer in its economic life can be demonstrated, to an extent sufficient to benefit fromutilities provided by the government, for example, infrastructure, public services and the legal system.[18]

As a result, in order to avoid exclusive taxation in the residence state, it is necessary to prove that a taxpayer carried ona business activity that was effectively integrated into the economic life of the source state. In this case, the attribution ofthe right to tax is regarded as compensation for costs incurred by the local government in developing the infrastructureused by the non-resident taxpayer to generate the income.

It is precisely in this context that the concept of a PE was developed as a minimum threshold that, once crossed, wouldindicate a significant economic presence of a foreign taxpayer in the source state, thereby permitting the taxation ofprofits generated within that state. In other words, on characterization as a PE, the economic allegiance required tojustify the taxation of income by the source state could be demonstrated. Conversely, in the absence of a PE, the lack ofreasonable grounds to justify the taxation of income earned in the source state by a resident of the other contracting statewould be acknowledged.[19]

14. K. van Raad. Cinco regras fundamentais para a aplicação de tratados para evitar a dupla-tributação, 1 Revista de Direito Tributário Internacional1, p. 204 (2005).

15. A. Xavier, Direito tributário internacional do Brasil p. 567 (Forense 2010).16. Id.17. A.T. Tavolaro, Fonte e Domicílio: Nova Configuração no Direito Tributário Internacional, in Direito Tributário Internacional pp. 31-49 (G. de Castro

Moreira Júnior & M. Magalhães Peixoto eds., MP Editora 2006).18. E.-E. López, An Opportunistic, and yet Appropriate, Revision of the Source Threshold for the Twenty-First Century Tax Treaties, 43 Intertax 1, p.

8 (2015).19. Id.


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By requiring a minimum level of presence in the source state, the concept of a PE gives precedence to the residencestate in the allocation of taxing rights,[20] which may tax all profits realized by the taxpayer through its economic activity.This preference for the residence state has always been a major challenge in the conclusion of tax treaties betweenstates with different levels of development due to the irregular flow of income within their economic relationship.

Indeed, due to the preference granted to the residence state, the allocation of taxing rights established in the OECDModel failed to deal with the problem of irregular or unequal income flows in the economic relationships between stateswith different levels of social, economic and political development. In fact, in the case of tax treaties concluded betweendeveloped and developing countries, the OECD Model tends to avoid double taxation by way of a loss of revenue on thepart of the developing country, as the net income derived from financial and commercial transactions between the statesgenerally flows from the developing country (i.e. the net capital importer) to the developed country (i.e. the net capitalexporter)[21] This is why the OECD Model is considered to be appropriate only for states that are at the same stage ofeconomic development and that exhibit a reciprocal flow of investment.[22]

Specifically, the income flow derived from economic relationships between states is unbalanced if a developing countrymay experience loss of tax revenue due to the reduction of the right to tax the income whose source is located within itsterritory. The problem is that this loss of tax revenue is not offset by an increase in the taxation of income obtained by itsresidents abroad, as, when it comes to developing countries, the number of domestic investors with financial conditionsto invest abroad is still considered to be low. This loss of tax revenue does not arise in respect of tax treaties concludedbetween two developed countries, as the reduced source taxation of income earned by non-residents is offset by anincrease in the taxation of income earned by their residents abroad.[23] Consequently, the concept of a PE arises, inthe context of an unbalanced allocation of taxing rights within the OECD Model, as a minimum standard that, only afterthe fulfilment of the requirements, permits the source state to exercise its right to tax the income derived from activitiesconducted on its territory.[24]

The success of the concept of a PE over the years can be evidenced by its use in almost all tax treaties; however, theconcept of a PE should not be elevated to the status of a principle of international tax law to be followed religiously inthe allocation of tax jurisdiction and taxing rights.[25] It is, rather, a criterion that should be used to measure the economicpresence of a taxpayer in the source state, which represents a compromise achieved by the League of Nations and isincluded in a number of tax treaties concluded by states. Consequently, it is an element that demonstrates the existenceof sufficient connection between the income, the taxpayer and the contracting state to justify the allocation of taxing rights.

3. Globalization and the Difficulty in Applying Traditional Concepts: The NewNuances of Source versus ResidenceThe expansion of international trade, the enlargement of the service sector, the growing process of regional economicintegration, the maximization of capital mobility and the increasing importance of new production factors have allcontributed to the erosion of the traditional definition of a PE as well as to its gradual change over time. The conceptof a PE as a fixed place of business in a specific geographical point has proven to be incompatible with the growthof e-commerce and the continued development of the internet. The typical elements of e-commerce hardly result incharacterization as a PE, at least in its traditional material definition.[26]

This phenomenon has not gone unnoticed by the OECD, which, with the political support of the G20 member countries,developed a comprehensive Action Plan to counter base erosion and profit shifting, with the declared aims of preservingtax revenues, sovereignty, neutrality and fairness. The OECD Base Erosion and Profit Shifting (BEPS) initiative[27]

20. F.O. Pita, Article 5 – The Concept of Permanent Establishment, in History of Tax Treaties – The Relevance of the OECD Documents for theInterpretation of Tax Treaties p. 231 (T. Ecker & G. Ressler eds., Linde 2011).

21. K.J. Holmes, International Tax Policy and Double Tax Treaties – An Introduction to Principles and Application 2nd edn., sec. 3.4.2. (IBFD 2014),Online Books IBFD.

22. F.N. Dornelles, A Dupla Tributação Internacional da Renda p. 50 (FGV 1979).23. Id.24. A.H. Schmitt, O Conceito de Estabelecimento Permanente conforme o Modelo da Convenção Fiscal da OCDE sobre o Rendimento e o Patrimônio

e o Comércio Eletrônico in Revista Tributária e de Finanças Públicas (E. Pereira de Brito ed.), 112 Revista dos Tribunais, p. 16 (2013).25. S.A. Rocha, Capítulo 4 – Imperialismo Fiscal Internacional e o ‘Princípio’ do Estabelecimento Permanente, Tributação Internacional pp. 95-97

(2013).26. J. Teodorovicz, O Estabelecimento Permanente no Direito Tributário Internacional: O Art. 5º das Convenções Modelos da ONU, OCDE e EUA in

Revista Tributária e de Finanças Públicas (E. Pereira de Brito ed.), 114 Revista dos Tribunais, pp. 120-122 (2014).27. See, for example, OECD, Addressing Base Erosion and Profit Shifting p. 5 (OECD 2013), International Organizations’ Documentation IBFD.


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contains two Action Plans that are directly related to the concept of a PE and are at the core of the conflict regarding theallocation of taxing rights between the source state and the residence state.

First, Action 1 of the OECD BEPS initiative deals with the challenges of the digital economy, of which the primarydilemma lies in the fact that many MNEs can develop businesses and have a significant economic presence in theconsumer market of other states without paying income tax, given the lack of a sufficient connection under the currenttax rules. Second, Action 7 of the OECD BEPS initiative is intended to counter the tax planning strategies used to avoidcharacterization as a PE by way of the use of commissionaire arrangements and the exploitation of exempt activities,which are exceptions to the PE concept provided in tax treaties based on the OECD Model.[28] For these reasons, thetrend followed by the OECD suggests the expansion of the definition of a PE and the adoption of more fluid and flexibleconcepts, thereby gradually diluting the classical concepts of a fixed place of business and a dependent agent.

4. The Reaction of Developing Countries: Taxation at Source of PaymentsDerived from Technical ServicesThe reaction of developing countries against the use of the outdated criteria with regard to the allocation of taxingrights between contracting states is evident in the case of taxation of remuneration derived from technical services. Thequestion of the balance in the allocation of taxing rights is particularly sensitive in the case of technical services, wherebyforeign companies can obtain a high return in the source state, even with no physical presence in that jurisdiction.

In order to safeguard the right of the source state in relation to such service activities, article 5(3) of the UN Modelincludes the concept of a PE in respect of services, which encompasses service activities performed in the source statefor a period exceeding 183 days in any 12-month period, i.e. a “service PE”. Despite the compromise solution envisagedin the UN Model, some developing countries maintained their position that the concept of a PE in respect of services isinsufficient to protect the interests of source states, as, given the current state of economic development, numerous typesof service can be provided at a distance, without the presence of employees or workers in the source state for 183 days.

Consequently, the insistence on the use of the concept of a PE as a criterion to legitimate the attribution of taxing rightsto the source state continues to attract significant criticism on the part of developing countries. This is especially so givenits unsuitability to tax services provided at distance, by means of which companies can exploit the local consumer marketwithout paying income tax.

On the other hand, developed countries maintained their initial position that only human activity can generate income,so that the mere exploitation of the consumer market is insufficient to justify the right to tax. In this sense, the primaryelement involved in the provision of technical services, i.e. the expertise of the professionals involved or humanresources, is located in the residence state, where the material activity was developed prior to its delivery to customerslocated in the source state. It, therefore, follows that, from the perspective of developed countries, income from technicalservices has a substantial relationship with the jurisdiction of the company that provides the services, in such a way thatthe concept of economic allegiance justifies the allocation of taxing rights exclusively to the residence state, except wherea PE is characterized in the source state.

In the context of this discussion, it should be noted that many developing countries, such as Argentina, Brazil, Gabon, theIvory Coast, the Philippines, Thailand, Tunisia and Vietnam, are in favour of including the remuneration from technicalservices or technical assistance in the definition of royalties in article 12 of the OECD Model. The intention behind this isto safeguard the right of these countries to tax such remuneration at source, regardless of the characterization of a PE.[29]

With regard to the taxation of technical services, the case of Brazil is a good example. Specifically, the Brazilian taxauthorities have issued Interpretative Declaratory Act RFB 5/2014.[30] This act deals with the classification of remunerationderived from technical services and technical assistance, with or without technology transfer, as perceived by individualsor legal entities resident in a state with which Brazil has concluded a tax treaty.

In Interpretative Declaratory Act RFB 5/2014, the Brazilian tax authorities adopted the following interpretations:

28. A Storck & A. Zeiler, Beyond the OECD Update 2014: Changes to the Concepts of Permanent Establishments in the Light of the BEPS Discussion,in The OECD-Model-Convention and its Update 2014 p. 242 (M. Lang et al. eds., Linde 2015).

29. OECD Model Tax Convention on Income and on Capital; Non-OECD Economies’ Positions on the OECD Model Tax Convention, Positions onArticle 12 (Royalties) and Its Commentary paras. 5-7 (26 July 2014), Models IBFD.

30. BR: Interpretative Declaratory Act RFB 5/2014, 16 June 2014.


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(1) the remuneration of technical services or technical assistance should be classified under article 12 (Royalties) of atax treaty, when this is expressly stated in the protocol to the tax treaty;

(2) in the case of provision of technical services and technical assistance dependent on the technical qualification of aperson or group of persons, the remuneration should be classified under article 14 (Independent personal services)of a tax treaty; and

(3) in all other cases, the remuneration derived from the provision of technical services should be classified underarticle 7 (Business profits) of a tax treaty.

With regard to Interpretative Declaratory Act RFB 5/2014, the scope of the fiscal policy adopted by Brazil in the protocolsto most of its tax treaties is open to discussion.[31] This policy makes the remuneration derived from the provision oftechnical assistance and technical services subject to the tax treatment for royalties.

It should be noted that Brazil is not the only state to follow a tax policy that seeks to tax at source the remunerationderived from technical services. India adopts a similar approach in some of its tax treaties. For example, article 13(1) and(2) of the India-UK Income Tax Treaty (1993)[32] reads as follows:

Article 13

Royalties and fees for technical services1. Royalties and fees for technical services arising in a Contracting State and paid to a resident of the other

Contracting State may be taxed in that other State.2. However, such royalties and fees for technical services may also be taxed in the Contracting State in which

they arise and according to the law of that State... (Emphasis added)

In the international sphere, the debate on the taxation of technical services gained new impetus with the approval, bythe Committee of Experts of the United Nations, of a new distributive rule to be included in the UN Model specifically todeal with the classification of remuneration derived from technical services. The objective of this new distributive rule is toallow the source state to levy withholding income tax on the gross amount remitted to non-residents, based on a rate tobe determined during the negotiations between the contracting states. As a result, this distributive rule would represent acarve out from the application of article 7 of the UN Model, which does not cover types of income classified under otherspecific distributive rules. Despite following the general interests of developing countries, the proposed new distributiverule raises various issues.

The first issue concerns the taxation of the gross price of the service provided, which can result in an effective tax burdenin the source state that is greater than that in the residence state. In such circumstances, the foreign tax credit grantedwould be limited to the tax due in the residence state on the same income.[33] Consequently, the taxation of the grossprice of the services could imply the payment of income tax in excess of the profit margin derived by the taxpayer, therebyviolating the ability-to-pay principle. By failing to take into account the different cost structures of each taxpayer, thelevying of withholding income tax on the gross amount could also result in the over-taxation of some income and theunder-taxation of other income.[34]

In order to obviate this problem, a taxpayer could opt to develop its economic activity through a PE to compel the sourcestate to tax only the profits, i.e. the net income, attributable to this economic activity. Alternatively, the taxpayer couldinclude a gross-up clause in the contractual instrument to transfer to the contracting party the economic burden of thewithholding tax levied at source. The immediate consequence of the second alternative will be an increase in the cost ofhiring non-residents in the source state.

On the other hand, from the perspective of developing countries, the taxation of the gross price derived from the provisionof services is simple and practical, as most countries do not have sufficient information to determine the net income

31. That is, in the tax treaties concluded by Brazil with Argentina, Belgium, Canada, Chile, China, the Czech Republic, Denmark, Ecuador, Hungary,India, Israel, Italy, Korea (Rep.), Luxembourg, Mexico, the Netherlands, Norway, Peru, Philippines, Portugal, the Slovak Republic, South Africa,Spain and Ukraine.

32. Convention between the Government of the United Kingdom of Great Britain and Northern Ireland and the Government of the Republic of Indiafor the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains (25 Jan. 1993),Treaties IBFD.

33. J. Schwarz, Schwarz on Tax Treaties 3rd edn. p. 238 (Wolters Kluwer 2013).34. R.C. Palma, The Paradox of Gross Taxation at Source, 38 Intertax 12, pp. 624-625 (2010).


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obtained by the non-resident. In these circumstances, a possible solution would be the adoption of a deemed tax base,with a profit margin pre-established with regard to the relevant business to which the withholding tax rate stated in the taxtreaty would be applied.[35]

The second issue relates to the concept of technical services. The concept of technical services, as included in the UNModel, extends to management, administrative, and advisory and consultancy services, except for amounts relating tothe reimbursement of expenses. The difficulty that may arise in this respect relates to the delimitation of the boundariesof the new distributive rule, as compared to those in articles 7 (Business profits), 12 (Royalties) and 14 (Independentservices) of the UN Model. The most viable alternative would be the inclusion, during the negotiation of tax treaties, ofa complete list of the services covered by the new distributive rule, which would be similar to that in article 13(4) of theIndia-UK Income Tax Treaty (1993).

The third issue relates to the determination of the source of income arising from the provision of services, as it is unclearas to whether the source state should be construed as that in which the individual or the legal entity that makes thepayment is located. Theoretically, the source may be the state in which:– the service was performed;– the results were verified;– the payment was made;– the expense was deducted from the taxable income; or– the contract was signed or executed.[36]

For this reason, instead of stating that the source state is that in which the payment arises, the UN Model could haveadopted a more objective criterion to avoid future discussion on this topic.

The fourth and final issue is that, although the OECD did not include the taxation of technical services within the BEPSproject, it should be noted that, for the developing countries, the source taxation of technical services provided by non-residents is not only a way of increasing tax revenue, but also a mechanism to counter the erosion of domestic tax baseseffected by way of payments made to non-resident companies.[37] For instance, in Brazil, article 6 of Decree-Law 1,418 of3 September 1975[38] states that the remuneration arising from the provision of services by non-residents is subject to thelevy of the withholding tax if the source of the payment is within Brazil, regardless of the form of payment and the place inwhich or date on which the transaction has been contracted, the services performed, or the assistance provided.

From the perspective of tax policy, the reasoning followed by the legislator has the clear objective of countering theerosion of tax bases in Brazil. As the payer can generally deduct the remuneration paid on account of technical servicesfrom the tax base of the corporate income tax (Imposto de renda das pessoas jurídicas, IRPJ) and the social contributionon net profit (Contribuição social sobre o lucro líquido, CSLL), the legislator decided that Brazil has the right to receive itsshare of the income paid to non-residents by way of the levying a withholding income tax at a rate that varies from 15% to25%, regardless of the characterization of a PE in Brazil.

5. The Reaction of Developed Countries and the Re-emergence of theImportance of the Consumer MarketThe OECD BEPS initiative has resurrected the debate regarding the adequacy and convenience of the concept of a PEwith regard to the allocation of the tax jurisdiction given the very significant pressure exerted by developed countries,which are G20 and OECD member countries, which had become the new losers in the conflict of source versusresidence. In particular, many European countries, which have become the major market for many US MNEs, such asAmazon, Apple, Google and Starbucks, have begun to demand more forcefully their right to tax at least part of the profitsderived by the MNEs in their territories.[39] It is in this context that the inconsistency in the approach adopted by developedcountries should be noted. Previously, the same European countries that now argue so strongly for the right to tax the

35. G.W. Rothmann, Tributação dos Serviços Importados na Legislação Doméstica e Internacional do Brasil, in Estudos de Direito Tributário emhomenagem do Professor Roque Antonio Carraza vol. 2, pp. 96-97 (F.D. Parisi ed., Malheiros 2014).

36. E.C.C.M. Kemmeren, Source of Income in Globalizing Economies: Overview of the Issues and a Plea for an Origin-Based Approach, 60 Bull. Intl.Taxn. 11, sec. 2. (2006), Journals IBFD.

37. B.J. Arnold, The Taxation of Income from Services, Papers on Selected Topics in Protecting the Tax Base of Developing Countries p. 3 (UN 2013).38. BR: Decree-Law 1,418, 3 Sept. 1975.39. López, supra n. 18, at p. 11.


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profits derived by US MNEs had rejected the arguments raised by developing countries to demand a fairer allocation oftaxing rights.

The exploitation of the market, which had been disowned by developed countries as justification for the attribution oftaxing rights to the source state, has now returned to international discussion under the auspices of the OECD BEPSinitiative. The concept of allocating tax jurisdiction to the country in which the income was generated reveals the intentionsof many OECD member countries, especially those in the European Union, to link the source of income to the placewhere the consumers of products or services are located.[40]

In this respect, an in-depth analysis of Action 1 of the OECD BEPS initiative reveals that the discussion regarding theconnection between digital activities and the source state for the purposes of allocating taxing rights deviates fromthe declared objective of the initiative, which is countering the erosion of tax bases and the artificial transfer of profits.Indeed, Action 1 of the OECD BEPS initiative does not just include proposals to counter tax avoidance with regard to e-commerce. On the contrary, in order to submit feasible proposals for the taxation of income derived from e-commerce,Action 1 of the OECD BEPS initiative attempts to redefine the parameters for the allocation of taxing rights between thesource state and the residence state with regard to transactions effected in the digital economy, thereby departing fromthe concept of physical presence as a prerequisite for the taxation of business profits.[41]

The final report of Action 1 of the OECD BEPS initiative[42] sets out a number of alternatives for the taxation of incomegenerated within the digital economy. The common point between the different proposals is precisely the need to assignto the state in which the consumer market is located the right to tax the profits derived by non-residents by way of suchtransactions. The proposals can be summarized as follows:[43]

(1) Changes in the negative list in respect of the definition of a PE: certain activities that were once considered to beancillary or preparatory and, therefore, not characterized as a PE have been considered by the OECD as beingessential functions of new business models. For instance, the OECD indicates that the storage of products, whichwas previously considered to be ancillary or preparatory, has become a central component for companies that sellproducts online and have warehouses in different countries to deliver the products to their customers as quickly aspossible. Consequently, with this change in the negative list, it would be possible to have a PE in the countries inwhich distribution centres are located. It, therefore, follows that the proposal is seeking to include the activities ofMNEs such as Amazon, which have distribution centres in several countries in Europe, but without, at present, thestatus of a PE.

(2) The amendment of the concept of a PE and the creation of parameters to assess the significant digital presence:as many economic activities are carried out exclusively in the digital environment, the OECD proposes to establishparameters to measure the digital presence of non-resident companies in the source state, for example, the volumeof data collected, the turnover resulting from sales to local customers, and the number of electronic contractsconcluded with customers and users in a specific jurisdiction.

(3) The introduction of a uniform criterion of significant presence that can be used for both physical and digital activities:another alternative suggested by the OECD involves the introduction of new parameters for the allocation of taxingrights to the source state, which would be applied to both physical and digital activities, such as: (i) customerrelationship for a period exceeding 6 months combined with given physical presence in the state in question; (ii)the sale of products or services on the internet or via other electronic devices, combined with the use of localinfrastructure for delivery, payment or other facilities; and (iii) the sale of products or services to customers in thesource state, involving the systematic collection of data and information.

(4) The imposition of withholding income tax on digital transactions: this proposal would permit the imposition of awithholding income tax on payments made by customers to purchase products or services offered by companiesabroad. Financial institutions would act as collecting agents, which would be required to withhold the tax from thepayments and to transfer the amounts to the states concerned.

40. Id.41. D.W. Blum, Permanent Establishments and Action 1 on the Digital Economy of the OECD Base Erosion and Profit Shifting Initiative – The Nexus

Criterion Redefined?, 69 Bull. Intl. Taxn. 6/7, sec. 3. (2015), Journals IBFD.42. OECD, Action 1 Final Report 2015 – Addressing the Tax Challenges of the Digital Economy (OECD 2015), International Organizations’

Documentation IBFD.43. A. Bal & C. Gutiérrez, Taxation of the Digital Economy, in International Tax Structures in the BEPS Era: An Analysis of Anti-Abuse Measures ch.

9 (M. Cotrut ed., IBFD 2015), Online Books IBFD.


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(5) The introduction of a “bit tax” on digital transactions: this alternative would involve the introduction of a new tax,whose tax base would be based on the number of bytes used by the website, along with some element to permit theprogressive taxation of the economic results as turnover or gross revenue.

From the analysis of these proposals, it is easy to see the growing importance that is being attached by the OECDmember countries to the source state[44] in which the consumer market is located. There is nothing wrong with the conceptof allocating tax jurisdiction to the state in which the consumer market is located. The consumer market is, undoubtedly,an important element in generating the income derived from cross-border transactions, as the same business effort canproduce different results, depending on the consumer market in question.[45] What draws attention in the debate is theinconsistency of the position of developed countries in the conflict of source versus residence.

On the one hand, the OECD member countries condemn developing countries with regard to the latter’s claim to taxtechnical services at source without the characterization of a PE within a state and for the latter’s intention to includelocation savings in transfer pricing adjustments. On the other hand, the OECD member countries are seeking to adoptmeasures for the preservation of their right to tax on the grounds that their consumer markets are exploited by US MNEsthat avoid the tax that is supposedly due.

In general, the final result of Action 1 of the OECD BEPS initiative is disappointing. Apparently, this can be attributed tothe strong resistance of the United States to the proposals presented by European countries to the OECD, as the USgovernment does not wish to reopen the dialogue regarding expansion of the taxing rights attributed to the source state.In this context, Danielle Rolfes, the US government adviser on international taxation, has stated that the United Stateswould not tolerate significant amendments to the concept of a PE, as argued by many countries in the course of theOECD BEPS initiative, although certain improvements could be justified. As a result, it appears that the position of theUnited States in maintaining the current paradigm with regard to international tax may frustrate the interests of Europeancountries in taxing a share of the profits earned by US MNEs, particularly in respect of e-commerce.[46]

In any case, the truth is that, regardless of the opposition of the United States, the proposals presented in Action 1 ofthe OECD BEPS initiative reveal an unsuccessful attempt to adapt outdated concepts to a new economic reality, withoutdirectly challenging the paradigms of international taxation. For instance, the proposed amendment to article 5(4) of theOECD Model to restrict the exceptions regarding “preparatory or auxiliary” activities and the new anti-fragmentation rule,which is designed to counter the use of these exemptions by way of the segregation of business activities among closelyrelated enterprises, would only have a limited effect, as it would only affect business models that still depend on thephysical delivery of product, for example, in online retail industries, such as Amazon. Consequently, this change wouldnot affect business models that function entirely electronically in dealing exclusively with intangible products.[47]

The progress experienced recently with regard to technology and information provided significant challenges to traditionalbusiness models, so that the mere verification of the physical presence, as having either a main or an auxiliary character,is an obsolete criterion for the purpose of allocating tax jurisdiction. In order to address these issues, Action 1 of theOECD BEPS initiative proposed the creation of a concept of PE that would assess the digital presence of a non-residenttaxpayer, which develops fully dematerialized digital activities, in such a way that products and services are exclusivelyprovided electronically.

The procedure to measure the digital presence of a non-resident company, which could involve the number of customers,the market share or the sales volume, raises important questions, not only because of the need to establish an objective,reasonable and non-arbitrary criterion, but also due to the difficulty in monitoring and quantifying the degree of the virtualpresence. A further critical point is the interaction of the concept of a PE with distributive rules in the OECD Model, otherthan article 7 (Business profits). For instance, the characterization of a PE in the source state may produce consequencesin the application article 6 (Immovable property), 10 (Dividends), 11 (Interest), 12 (Royalties), 13 (Capital gains), 15(Income from employment), 21 (Other income), 22 (Capital) and 24 (Non-discrimination).[48] In this context, Action 1 ofthe OECD BEPS initiative does not address how a merely virtual PE would interact with the other distributive rules in theOECD Model.

44. Y. Brauner, BEPS: An Interim Evaluation, 6 World Tax J. 1, sec. 2. (2014), Journals IBFD.45. In the words of L.E. Schoueri, Preços de Transferência no Direito Tributário Brasileiro 3rd edn., p. 50 (Dialética 2013): “... the market, either the

one that offers the production factors (labor, raw materials etc.) or the one where the products are sold, is relevant to the generation of profits. Thesame entrepreneurial effort will have different results, depending on the market concerned” (authors’ unofficial translation).

46. López, supra n. 18, at p. 13.47. Blum, supra n. 41, at sec. 3.3.48. Id., at sec. 4.1.


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The greatest difficulty appears, however, to lie in the attribution of profits to a virtual PE, which would involve thesimultaneous application of two fictions. These are: (i) the fictitious characterization of a virtual PE; and (ii) the fictitiousindependence of a PE for the purposes of profit allocation.

According to the Authorised OECD Approach (AOA), the attribution of profits to a PE must be based on the assets used,the functions performed and risks assumed on the basis of the fiction that the head office and the PE are independentlegal entities. The difficulty that arises here is how to undertake a functional analysis in respect of a PE that only existsin the virtual world, without assuming risks, performing functions or using the assets to develop concrete activitiesin the source state. The only alternative would be the adoption of simplified parameters or rebuttable presumptions,although, from a practical standpoint, it would be very difficult to enforce a tax law based on a concept of a virtual PE. Theregulatory difficulties involved in controlling the internet demonstrate that the effectiveness of laws directed at the virtualenvironment is reduced. This could encourage countries to adopt alternative solutions to resolve the issues arising frome-commerce. This is what happened in the United Kingdom with the introduction of the DPT (see section 6.).

In short, the preceding comments reveal that the OECD has insisted on maintaining the current paradigms of internationaltaxation, in seeking only to adapt outdated concepts to a new economic scenario.[49] The clear link of the new proposals tothe concept of a PE and the insistence of the OECD on the use of the arm’s length standard demonstrates that the breakwith the traditional model and the introduction of a new paradigm in the area of international taxation, based on unitarytaxation of corporate groups, i.e. formulary apportionment (FA) and the EU Common Consolidated Corporate Tax Base(CCCTB), still face strong resistance within the OECD. This, in turn, complicates the adjustment of tax laws to the newdevelopments.

6. The DPT in the United KingdomIn April 2015, the United Kingdom introduced in its domestic law the DPT with the stated objective of dealing with theaggressive tax planning used by MNEs to transfer profits from the UK jurisdiction by use of business structures thatprevent the characterization of a PE in the United Kingdom, either by way of artificial legal transactions or through the useof entities without economic substance. The DPT applies to situations where a non-resident company provides goods,services or other products in the United Kingdom by way of a business model that avoids the characterization of a PE.[50]

The DPT is levied at a rate of 25%, which is higher than the current UK corporation tax rate of 20%. The tax basecorresponds to the profit that would be attributed to a PE if such a presence in the United Kingdom had not been avoidedby the taxpayer. The profits to be taxed by the DPT are calculated based on the same domestic rules governing theallocation of profits to a PE.

The DPT is the single greatest proof of the inconsistency in the stance of certain European countries in the conflictbetween source and residence. The main argument used by developed countries against the taxation of technicalservices at source was the absence of a PE to demonstrate the existence of an effective connection with its jurisdiction.However, as soon as US MNEs, such as Apple, Amazon, Google and Starbucks, began to sell their products in theUK consumer market without the characterization of a PE and, the payment of a fair share of tax, the United Kingdomenacted the DPT to ensure that a portion of the profit derived by these MNEs is taxed in the United Kingdom.

Despite the possible justifications for its creation, the compatibility of the DPT with the tax treaties concluded by theUnited Kingdom is very questionable. First, the rules regarding the DPT do not only apply to cases where the sole or mainpurpose of the taxpayer is to avoid taxes, which would be essential to characterize the rule as an anti-abuse provision. Insuch a case, UK law would be no more than a mechanism to permit the taxation of any sales or services undertaken inthe UK internal market, regardless of the characterization of a PE, which flagrantly contradicts article 7 (Business profits)of the tax treaties concluded by the United Kingdom.

Second, the deemed characterization of a PE based on a domestic anti-abuse rule without support in the wording of a taxtreaty could result in double taxation, as the residence state only grants an exemption or a foreign tax credit in relation tothe tax charged in accordance with the distributive rules of the tax treaty.[51] As a result, the imposition of the DPT by theUnited Kingdom could lead to the double taxation of corporate profits, which is precisely what the relevant tax treaty isintended to avoid.

49. Brauner, supra n. 44, at sec. 4.50. UK: Finance Act (FA), 2015, sec. 86.51. M. Helminen, The International Tax Law Concept of Dividend, Series on International Taxation, vol. 36, pp. 105-106 (Kluwer L. Intl. 2010).


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Third and finally, it should be noted that a similar solution was proposed in Australia in a report entitled “Tax Integrityof Multinational Anti Avoidance Law”, but with the establishment of more stringent and specific requirements. Theserequirements would have included the following:(1) a transaction would have to have been undertaken to avoid the characterization of a PE in Australia;(2) the main purpose, or one of the main purposes, of the taxpayer would have to have been a tax savings with regard

to Australian tax;(3) the income of the non-resident taxpayer would have to have exceeded AUD 1 billion; and(4) the non-resident would have to have had links with tax havens.

Consequently, although these criteria could raise several issues, it is clear that the legislative proposal as advanced byAustralia sought to clarify its anti-abusive character, thereby reducing disputes that could arise in respect of tax treaties.

7. Conclusions: The Need To Resolve the Dichotomy between Source andResidenceAs noted in section 2., tax treaties are based on the general rule that the profits arising from the exercise of economicactivity in the source state by a person resident in the other contracting state, i.e. the residence state, are only taxed inthe source state if such a person has a PE (as defined in article 7 of the OECD Model) in its territory. If this is not thecase, the right to tax such income is exercised exclusively by the residence state. However, this general rule is subject toexceptions, such as the types of income explicitly listed in other distributive rules, i.e. in articles 6, 8, 10, 11, 12, 16, 17,18 and 19 of the OECD Model, where the allocation of tax jurisdiction may be cumulative, i.e. to both the source stateand the residence state, or exclusive, i.e. to the source state or the residence state. The problem is that this allocation oftaxing rights, which is based on the dichotomy between source and residence, is now being questioned, as it no longermeets the interests of both the source state and the residence state.

From the perspective of the residence state, the different criteria, i.e. “place of incorporation” or “place of management”,used by countries to define residence, permit the existence of legal entities that are not resident in any of the statesinvolved. Advances in the digital economy have also started to permit the management of legal entities remotely, withoutrequiring the presence of the board of directors in a specific jurisdiction, thereby avoiding the characterization of a “placeof management”.

On the other hand, from the perspective of the source state, MNEs can sell their products and services to customersin several countries digitally without any physical presence in a country. As a result, an MNE can avoid both thecharacterization of a PE in the source state and the connection of the MNE’s profit with the activities undertaken bydependent agents in the source state. The attempt by the OECD to establish a new form of digital link with the sourcestate to tax economic activities undertaken in virtual environments only appears to result in complexity and uncertaintygiven the difficulties of enforcement and compliance.

Consequently, there is a pressing need to resolve the current paradigm that guides international tax law, as the dichotomybetween source and residence in the allocation of taxing rights has not kept pace with economic development and thechanges in the business models of many MNEs. This has resulted in the current trend followed by some developed anddeveloping countries to adopt a new model, based on the exercise of taxing rights by the state in which the consumermarket is being exploited by an MNE, regardless of the residence of the economic agent who receives the income.

This new taxation model is, however, not immune to criticism, as it raises the question of the core distinction betweenincome and consumption taxes. Traditionally, an income tax levied on business profits is associated with the state inwhich the production factors that enable the exercise of economic activity are located, while the consumption of goodsand services is subject to the levying of consumption taxes in the destination state, where the consumer market isexploited. The allocation of tax jurisdiction to the state in which the consumer market is located, as intended in thenew global scenario, makes income taxes similar to consumption taxes, as it is impossible to charge a broad andcomprehensive income tax on a taxpayer who has no physical presence in a state.[52]

All taxes always fall under concept of income, although captured at different times, i.e. earned income, savings andconsumed income. It is, therefore, possible to consider whether income taxes can survive, at least in their current form.The policies adopted by some countries that have developed new taxes to follow economic development, such as theDPT as introduced in the United Kingdom, reveal that the current form of the corporate income tax does not conform with

52. For more on this, see Bal & Gutiérrez, supra n. 43.


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the claim to be able to tax sales of goods and services undertaken in a given consumer market, even without any physicalpresence in a country. The various legislative proposals for the creation of specific taxes in respect of digital transactions,such as the “web tax” introduced in Italy,[53] also exhibit the difficulties that the current model of corporate taxation posesfor countries.

It must, however, be stated that the proliferation of new taxes is not the right way to reform the international tax system,as the lack of coordination between countries in the introduction of new taxes significantly increases the risk of doubletaxation. The residence state, for example, may not agree to grant tax credits in relation to the DPT collected in the UnitedKingdom, as this tax appears to breach article 7 of tax treaties based on the OECD Model. Such double taxation is amajor disadvantage in the development of the international tax regime, which since the 1920s has worked to preventexcessive tax burdens arising in relation to cross-border transactions, as it represents an obstacle to the internationaltrade in goods and services.

Finally, this demonstrates the need for a firmer position on the part of the G20 and OECD member countries in exercisingleadership for the effective reform of the international tax system that would avoid double taxation. Otherwise, it willbe possible to envisage more and more countries starting to focus on their own interests at the expense of economicdevelopment. Unfortunately, such a firm position to be expected from the OECD is not what can be seen in practice. Onthe contrary, the reports prepared under the OECD BEPS initiative have, to date, been disappointing, which reveals onlythe insistence on the use of outdated concepts in respect of international taxation, in an unsuccessful attempt to adaptthese to the new reality.

53. IT: Law 147, 27 Dec. 2013.


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