The United Kingdom’ s Diverted Profits Tax and Tax Treaties: An Evaluation

399© IBFD BULLETIN FOR INTERNATIONAL TAXATION JULY 2016

The United Kingdom’ s Diverted Profits Tax and Tax Treaties: An EvaluationThis article examines the diverted profits tax (DPT) introduced by the United Kingdom to counter aggressive tax planning adopted by many multinational enterprises so as to transfer profits from its jurisdiction, and the main controversies surrounding the compatibility of the DPT with tax treaties.

1. Introduction

In April 2015, the United Kingdom introduced the diverted profits tax (DPT) into its domestic law. The DPT has the declared objective of countering aggressive tax planning as used by many multinational enterprises (MNEs) to transfer profits from the United Kingdom’ s jurisdiction by way of business structures that prevent the charac-terization of a permanent establishment (PE) within the United Kingdom, either by the use artificial transactions or of entities without economic substance.

This article deals specifically with the DPT levied when a foreign company carries on activities in the United Kingdom by means of a structure that is designed to avoid the creation of a PE, i.e. a taxable presence, in the United Kingdom. In such circumstances, the DPT targets situ-ations where a non-resident company provides goods, ser-vices or other properties in the United Kingdom through a business model that avoids the characterization of a PE.1

The DPT is levied at a rate of 25%, which is higher than the current standard corporation tax rate of 20% levied in the United Kingdom. The tax base corresponds to the profits that would have been attributed to the PE if its presence had not been prevented by the taxpayer. The profits to be subject to the DPT are calculated using the same domestic tax rules that govern the allocation of profits to PEs located in the United Kingdom.

The DPT may be considered the greatest proof of inconsist-ency in the attitude of certain European countries regard-ing the debate on the allocation of taxing rights between the source state and the residence state. In the recent past, the main argument used by developed countries against the taxation at source of technical services and adminis-trative assistance was the absence of a PE in the source

* Master of Laws (LL.M.) in international taxation, Vienna Wirtschafts-universität Wien (University of Economics and Business, WU) and Master of Laws candidate in tax law, University of São Paulo (USP), Member of the Scientific Committee, postgraduate course in interna-tional tax law of the Brazilian Institute of Tax Law (IBDT) and Visiting Professor, postgraduate courses in Brazil, and Tax Associate, Mariz de Oliveira e Siqueira Campos Advogados. The author can be contacted at [email protected]

1. UK: Finance Act 2015, sec. 86.

state, thereby being able to demonstrate the existence of an effective connection with its jurisdiction. However, as soon as some US MNEs started to sell their products in the UK consumer market without paying a supposedly “fair share of tax”, the United Kingdom quickly introduced the DPT into its national tax system to ensure the taxation of a portion of the profit derived by such MNEs in its territory. Despite all reasonable justifications for the adoption of this unilateral tax measure, which departs from the proposals presented by the OECD Base Erosion and Profit Shifting (BEPS) initiative,2 the compatibility of the DPT with tax treaties is very questionable.

2. The DPT and the Material Scope of Tax Treaties

As reported, the UK government decided to implement a new tax levied on diverted profits with the deliberate intention of excluding the tax from the material scope of its tax treaties. However, regardless of the unilateral position adopted by the UK government, the DPT should be exam-ined carefully to verify whether it falls within tax treaties based on the OECD Model.3

In this context, it should be noted that article 2 of the OECD Model, which deals with the taxes covered by a tax treaty, reads as follows:

1. This convention shall apply to taxes on income and on capital imposed on behalf of a Contract-ing State or of its political subdivisions or local authorities, irrespective of the manner in which they are levied.

2. There shall be regarded as taxes on income and on capital all taxes imposed on total income, on total capital, or on elements of income or of capital, including taxed on gains from the alienation of movable or immovable property, taxed on the total amounts of wages or salaries paid by enterprises, as well as taxes on capital appreciation.

(...)

4. The Convention shall apply also to any identical or substantially similar taxes that are imposed after the date of signature of the Convention in addi-tion to, or in place of, the existing taxes. The com-petent authorities of the Contracting States shall

2. See, for example, OECD, Addressing Base Erosion and Profit Shifting (OECD 2013), International Organizations’ Documentation IBFD and OECD, Action Plan on Base Erosion and Profit Shifting (OECD 2013), In-ternational Organizations’ Documentation IBFD.

3. Most recently, OECD Model Tax Convention on Income and on Capital (26 July 2014), Models IBFD.

Ramon Tomazela Santos*International/United Kingdom

Exported / Printed on 20 July 2016 by [email protected].

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Ramon Tomazela Santos

notify each other of any significant changes that have been made in their taxation laws.

As can be seen, article 2 of the OECD Model covers any taxes levied on total income or on specific types of income earned by taxpayers, regardless of the political subdivision in state and the method of collection, for example, income tax withheld at source or income tax levied on the basis of a tax return.

In addition, identical or substantially similar taxes imposed after the date of the signature of the tax treaty are also covered in article 2(4) of the OECD Model. Indeed, this provision contains an extension clause, which encom-passes taxes introduced after the conclusion of a tax treaty if they are identical or substantially similar to the taxes originally covered. Such an extension clause preserves the application of a tax treaty over the time, as it avoids the fact that amendments to domestic laws make a tax treaty inoperative. It also relieves the contracting states from the obligation of renegotiating a tax treaty on each modification of their domestic laws. Consequently, if the new taxes imposed are identical or substantially similar to those covered by the tax treaty, the levying of such tax should comply with the treaty provisions agreed by the contracting states.4

In general, the term “tax” means any charge levied by an authority of a sovereign state on a person or property under its jurisdiction to obtain financial resources to cover general public expenditure.5 As a result, the term “tax” has a broad and generic meaning that encompasses almost all amounts levied by a state based on its sovereignty, with a few exceptions, such as the charges relating to administra-tive policing powers, which are often referred to as “fees”. All others forms of taxation, such as duties, excises and social contributions, may be included in the broad concept of “tax”. Specifically with regard to the income tax, article 2(2) of the OECD Model adopts a very broad wording, which covers not only a comprehensive income tax levied on the total income earned by a taxpayer, but also specific taxes that are levied on particular types of income.6 Appar-ently, this broad definition could apply to the DPT levied on the profits diverted from the United Kingdom’ s market.

In contrast, it could be argued that the DPT is not sub-stantially similar to income tax, as it has a specific scope that encompasses a narrow number of taxpayers, as well as a different tax rate. However, article 2(2) of the OECD Model also covers tax levied on elements of income, such as in a schedular income tax system, in which separate taxes are imposed on different categories of income. In addition, the applicable tax rate is not a decisive element in defining whether a new tax is covered by article 2 of the OECD Model, as it only quantifies the amount to be paid to the government treasury, without determining the legal nature of the tax due.

4. M. Lang, Introduction to the Law of Double Taxation Conventions, 2nd edn., sec. 8. (IBFD/Linde 2013), Online Books IBFD.

5. A. Sampaio de Moraes Godoy, Direito Tributário International Contextu-alizado pp. 28-119 (Quartier Latin 2009).

6. J. Hortalá i Vallvé, Comentarios a la Red Española de Convenios de Doble Imposición pp. 65-66 (Thomson/Aranzadi 2007).

Further, the definition of PE is directly connected with article 7 of tax treaties, which is the allocation rule applied to business profits. As a consequence, if a country creates a new type of tax that is levied on PEs, or on MNEs that avoided the creation of a PE, on diverted profits, such a tax would clearly fall within the material scope of tax treaties. In the case under consideration, even the name of the new tax indicates that it is levied on profits.

Strictly, the DPT is substantially similar to an income tax, as its tax base corresponds exactly to the profits that would have been attributed to a PE had a taxpayer had not avoided such a characterization in the United Kingdom. The tax base is usually considered to be the most important factor in identifying the similarities between new taxes and taxes covered by article 2 of tax treaties. As a result, given the similarities in the computation rules, it would appear that the differences between the DPT and the regular income tax levied on a PE in the United Kingdom are not so great as to prevent the DPT from being regarded as a tax sub-stantially similar to the income tax. It follows that, despite the manoeuvre used by the United Kingdom to implement a new tax, the DPT is covered by the material scope of its tax treaties.

3. The DPT and the Equivalent of Article 7 of the OECD Model in Tax Treaties

Assuming that the DPT is a substantially similar tax, the question to be answered concerns its compatibility with article 7 of tax treaties based on the OECD Model, given that the United Kingdom intends to tax profits earned by a non-resident company, regardless of the effective char-acterization of a PE in its jurisdiction. In other words, the question that arises is whether, in the event that the non-resident company is headquartered in a state that has con-cluded a tax treaty with the United Kingdom, the UK gov-ernment may levy the DPT on profits allegedly diverted, even without the effective characterization of a PE within the state.

Article 7(1) of the OECD Model, as adopted by the United Kingdom in most of its tax treaties, reads as follows:

Profits of an enterprise of a Contracting States shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment sit-uated therein. If the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that other State.

Article 7(1) of tax treaties has the objective scope of pro-tecting the profits earned by individuals or legal entities resident in the other contracting state through the devel-opment of an economic activity.7 Consequently, profits arising from the exercise of a business activity should be taxed exclusively in the residence state. The only excep-tions to this general rule rely on the economic activity per-

7. L.E. Schoueri, The Objective Scope of Article 7 and the Treaty Protection to Deemed Distributed Dividends Kluwer Intl. Tax Blog (2015), available at http://www.kluwertaxlawblog.com/blog/2015/04/27/the-objective-

scope-of-article-7-and-the-treaty-protection-to-deemed-distributed- dividends/.



The United Kingdom’ s Diverted Profits Tax and Tax Treaties: An Evaluation

formed in the source state being undertaken by way of a PE, as well as on the income being classified under specific distributive rules, which establish a specific allocation of the right to tax.

It is, therefore, clear that article 7 of the OECD Model has a universal scope, thereby serving as an umbrella for differ-ent types of income derived from business activities. The reason for this is because it covers the results arising from the exercise of an economic activity conducted by a resi-dent 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 dealt with in one of the specific distributive rules. That is why article 7(1) of the OECD Model may be considered to be the heart of a tax treaty, under which the largest portion of income derived from international economic activities is classified.8

The definition of PE set out in article 5 of the OECD Model is one of the key concepts in tax treaties for the alloca-tion of taxing rights relating to foreign business activities. This is because the concept of a PE serves as a criterion to legitimate the attribution of the taxing rights to the source state. It also indicates a substantial degree of presence in the economic life of the source state, which justifies the taxation of a foreign person on the profits attributable to the business activity developed in its consumer market, in the same way as a domestic person.

Nevertheless, as the wording of the definition of a PE has remained nearly unchanged for the last 50 years,9 new business models developed during the last decades allow taxpayers to derive a high level of income without a physi-cal presence in the host state. MNEs can, therefore, have a significant business presence in the economy of another state, without becoming liable to tax due to the lack of nexus under the current definition of a PE.

The DPT is intended to counter the artificial avoidance of the status of a PE. However, the DPT does not appear to differentiate between situations in which a taxpayer simply does not have a fixed place of business in the source state over a particular duration of time from those in which a taxpayer effectively makes use of schemes or pre-planned arrangements that are designed to artificially avoid the characterization of a PE in the source state.

Article 5 of the OECD Model deals with the following three different types of PEs: (1) a general PE; (2) a con-struction PE; and (3) a dependent agent PE. Each of these definitions of a PE requires the presence of certain ele-ments for its characterization, such as, inter alia: (1) a ter-ritorial link evidenced by a fixed place of business; (2) a time threshold that indicates the level of permanence; and (3) the authority to conclude contracts in the name of the enterprise. All of these concepts and requirements may be used by the taxpayer to design a business model that avoids the characterization of a PE in the source state, thereby

8. A. Xavier, Direito tributário internacional do Brasil p. 567 (Forense 2010).9. A. Storck & A. Zeiler, Beyond the OECD Update 2014: Changes to the Con-

cepts of Permanent Establishment in the Light of the BEPS Discussion, in The OECD-Model-Convention and its Update 2014 sec. I, p. 242 (M. Lang et al. eds., IBFD/Linde 2015), Online Books IBFD.

reducing its tax burden. As a result, the current rules leave room for the use of valid tax planning strategies in rela-tion to the definition of a PE, as new economic activities and technological developments offer a reasonable degree of flexibility for the taxpayers to structure their business without crossing the PE threshold.

Article 5(4) of the OECD Model also contains a list of preparatory or auxiliary activities that are to be treated as exceptions to the general definition of a PE, even when a fixed place of business is characterized. Although orig-inally designed for a different economic context, these exemptions are granted by the treaty provision itself. As a result, the simple adoption of a business model that either avoids the characterization of a PE or exploits the exemp-tions for preparatory or auxiliary activities cannot be con-sidered to be the artificial avoidance of the status of a PE.

In practice, it is unclear whether the DPT only encom-passes cases where a taxpayer artificially avoids the char-acterization of a PE in the market jurisdiction through the artificial fragmentation of its transaction. As the relevant UK law is drafted in broad terms, it is very likely that the DPT also affects cases in which the taxpayer designs its business model to fall within the PE threshold, but without using transactions structured in an artificial manner. In this respect, only artificial structures, instigated exclu-sively for tax purposes and with no economic substance, should be countered by tax authorities.

If the structure adopted by a taxpayer is congruent with the business model chosen, the tax authorities cannot dis-regard a valid tax planning strategy just because it reduces the tax liability in the source state. Conversely, when the structure used by the taxpayer does not have a certain degree of economic substance and coherence, the tax authorities may counter it, irrespective of the introduc-tion of a specific tax for that purpose.

The problem is that the United Kingdom intends to levy the DPT on international structures adopted by MNEs that were not intended to be covered by the PE definition as originally drafted. Nevertheless, as these structures are not artificial from a legal standpoint, the United Kingdom should, in theory, renegotiate its tax treaties to amend the definition of a PE, instead of levying a new tax.

As taxpayers have the right to choose the legal actions and transactions that best fit their needs, the simple fact that the business model adopted falls within the definition of a PE does not, in itself, authorize the collection of a substan-tially similar tax that contradicts the international obliga-tions assumed in a tax treaty. This is why the levying of the DPT should be restricted to cases where the tax authorities can demonstrate the artificiality of the legal structure used by the taxpayer or, at best, the lack of any other plausible justification for the means adopted.

Recently, the OECD BEPS initiative has resurrected the debate regarding the adequacy and convenience of the concept of a PE with regard to the allocation of the tax jurisdiction given the very significant pressure exerted by developed countries. In particular, numerous European countries, which have become a major market for many


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US MNEs, such as Amazon, Apple, Google and Starbucks, have begun to demand more forcefully their right to tax at least part of the profits derived by such MNEs in their territories.

However, the proposals presented in Action 7 of the OECD BEPS initiative reveal an unsuccessful attempt to adapt an outdated concept to a new economic reality, without directly challenging the paradigms of interna-tional taxation.10 Action 7 only targets circumvention of the PE definition, i.e. artificial fragmentation, commis-sionaire arrangements, preparatory or auxiliary exemp-tions, among others, without departing from the current rules on the allocation of taxing rights between contract-ing states. Consequently, as in the vast majority of Action Plans in its BEPS initiative, the OECD has insisted on maintaining the current paradigms of international taxa-tion, in seeking only to adapt outdated concepts to a new economic scenario.

The amendment of the PE definition, as envisaged under Action 7 of the OECD BEPS initiative, would most prob-ably not encompass all cases in which foreign enterprises can undertake a substantial level of economic activity in the source state without establishing the degree of presence required by the PE threshold. Against this background, it is easy to see why the United Kingdom decided to enact the DPT to ensure the taxation of a portion of the profit derived by such MNEs. The United Kingdom probably found the approach followed by the OECD in Action 7 ineffective and, therefore, opted for the introduction of a more radical tax measure that targets profits diverted to other countries.

The point is that, despite all possible justifications, the compatibility of the DPT with article 7 of the tax treaties concluded by the United Kingdom is very questionable. The various specific objections to the DPT with regard to tax treaties are now summarized below.

First, the rules regarding the DPT do not only apply to cases where the sole or main purpose of the taxpayer is to avoid taxes. This would be essential in characterizing the rule in the DPT as an anti-abuse provision. The use of UK law is a simple mechanism that permits the taxation of any sales or services undertaken in the UK internal market, regardless of the characterization of a PE. This flagrantly contradicts article 7 of the tax treaties.

Second, the deemed characterization of a PE based on a domestic anti-abuse rule without the support of the wording in a tax treaty could result in double taxation, as a residence state only grants an exemption or a foreign tax credit in relation to taxes levied in accordance with the distributive rules of a tax treaty. Consequently, the imposi-tion of the DPT by the United Kingdom could result in the double taxation of corporate profits, which is precisely the phenomenon that a tax treaty is intended to avoid.

10. OECD, Action 7 Final Report 2015 – Preventing the Artificial Avoidance of Permanent Establishment Status (OECD 2015), International Organiza-tions’ Documentation IBFD.

This demonstrates that the United Kingdom should have extended or amended the definition of a PE in its tax trea-ties to encompass new activities developed without a phys-ical presence within the country. The United Kingdom could also have included in its tax treaties specific anti-avoidance rules against common tax planning strategies used to avoid the characterization of a PE. What cannot be agreed to is the introduction of a new tax to cover these situations which violate treaty obligations.

The conclusion would be different if the DPT were to be levied only when the taxpayer’ s conduct consisted of con-cealing the existence of a PE in the source state by means of fraudulent manoeuvres. However, as the UK law is drafted in broad terms, it would appear that, in several cases where a structure used by a taxpayer could not be considered to be artificial, the levying of the DPT by the UK tax authori-ties, Her Majesty’ s Revenue & Customs (HMRC), would be incompatible with tax treaties.

4. Domestic Anti-Avoidance Rules and Tax Treaties

Despite the protection granted by article 7 of the OECD Model, HMRC could argue that the DPT would only be levied in abusive situations involving the requalification of legal structures used by taxpayers as artificially circum-venting the concept of PE. Based on this, HMRC could argue that, with the support of the OECD’ s position on the compatibility of domestic general anti-avoidance rules (GAARs) with treaty provisions, the mere requalification of the facts, to be able to consider that there is a PE in the United Kingdom, would not be affected by tax treaties. This line of reasoning would allow the collection of the DPT even in the face of a tax treaty.

In fact, the OECD argues, in the Commentary on Article 1 of the OECD Model, that:

... to the extent these anti-avoidance rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability, they are not addressed in tax trea-ties and therefore not affected by them. Thus, as a general rule, there will be no conflict between such rules and the provisions of tax conventions.11

This interpretation of the compatibility of domestic GAARs with the tax treaties, which is reinforced in the Commen-tary on Article 1 of the OECD Model,12 is adopted by most OECD member countries. The only exceptions are Lux-embourg, the Netherlands and Switzerland, which have recorded observations against such a questionable inter-pretation as proposed by the OECD.13

This is not the place to review this subject in all of its vari-eties. It is, however, important to present brief comments regarding the position of the OECD on the compatibility of domestic GAARs with treaty provisions.

Initially, it should be emphasized that the title of and the preamble to tax treaties includes the purpose of avoiding

11. OECD Model Tax Convention on Income and on Capital: Commentary on Article 1, para. 9.2 (26 July 2014), Models IBFD.

12. Id., at paras. 22.1 and 23.13. Id., at paras. 27.6, 27.7 and 27.9.




double taxation and the prevention of tax evasion. As a result, even if a prescriptive content is assigned to the pre-amble of tax treaties, it is clear that domestic anti-abuse rules may only be applied in conflict with the provisions of tax treaties in the event of demonstrable tax evasion,14 but not in the case of tax avoidance or tax mitigation.

The passages of the Commentaries on the OECD Model that use the term “tax avoidance” are mainly related to the exchange of information and administrative assistance in the collection of taxes. Consequently, it is not possible to include the efforts aimed at tax avoidance as a general objective of tax treaties, which should guide the interpre-tation of their provisions, in the light of article 31(1) of the Vienna Convention on the Law of Treaties (the Vienna Convention) (1969).15

In addition, in other passages that refer to the need to counter tax avoidance, it has been expressly decided to include specific anti-avoidance measures in the OECD Model, such as: (1) the concept of beneficial owner in art-icles 10 (Dividends), 11 (Interest) and 12 (Royalties); (2) the replacement of the expression “each fiscal year” with “any twelve month period” in article 15 (Income from employment); and (3) the inclusion of article 17(2) (Enter-tainers and Sportspersons), which permits the taxation at source of income attributed to star companies, regardless of the use of an artificial structure by the entertainer or sportsperson.

These examples demonstrate that, in order to deal with tax avoidance, states should amend the wording of treaty provisions to prevent their circumvention by taxpayers by way of tax planning, rather than simply implement domestic anti-avoidance rules that overlap with the obli-gations assumed at an international level, which consti-tutes a treaty override.16

The application of domestic anti-avoidance rules may also result in an unilateral change of a tax treatment granted by a tax treaty, as the tax obligation created by the domestic law of a contracting state, based on its interaction with the domestic anti-avoidance rules, may modify or frustrate the effects that could have been derived from the application of the tax treaty.17 This is precisely what may happen in the case under analysis, as the DPT as levied by the United Kingdom frustrates the typical effects derived from article 7 of the OECD Model, which provides for the exclusive taxation of business profits in the residence state, except where a PE can be characterized in the source state, which does not occur in the case of the DPT.

In addition, the position expressed by the OECD in para-graph 9.2 of the Commentary on Article 1 of the OECD

14. G. Maisto, Domestic Anti-Abuse Rules and Bilateral Tax Conventions in the Light of Public International Law, in Essays on Tax Treaties A Tribute to David A. Ward pp. 334/335 (G. Maisto, A. Nikolakakis & J.M. Ulmer eds., IBFD/CTF 2012).

15. UN Vienna Convention on the Law of Treaties (23 May 1969), Treaties IBFD.16. With regard to treaty override, see L.E. Schoueri, Tax Treaty Override A

Jurisdictional Approach, 42 Intertax 11 (2014) and C. de Pietro, Tax Treaty Override (Kluwer L. Intl. 2014).

17. Maisto, supra n. 14, at p. 336.

Model was only first included in 2003.18 This makes its application questionable with regard to tax treaties con-cluded before 2003.

It is known that the OECD argues that the amendments to the Commentaries on the OECD Model are not rele-vant for the interpretation and application of tax treaties concluded prior to their issue when there is a difference in substance.19 On the other hand, where the amendments to the OECD Commentaries are regarded as merely inter-pretive, the OECD argues that such clarifications should be applied to existing tax treaties20,21 to the extent that they reflect the consensus of the OECD member coun-tries regarding the correct interpretation of existing treaty provisions and their proper application to actual cases.22,23

It can sometimes be difficult to identify whether a change to the Commentaries on the OECD Model has instituted a substantial change in the underlying treaty provision, especially when the wording of the OECD Model itself remains unchanged.24 Despite this, when it comes to the compatibility of domestic anti-abuse rules with tax trea-ties, the new position adopted by the OECD is diamet-rically opposed to that which had been adopted by the OECD since the Commentaries on the OECD Model (1977),25 which makes the change made in the Commen-taries on the OECD Model 2003 applicable only to tax treaties entered into after that date.26 In fact, the pre-2003 version of the Commentaries on the OECD Model sug-gested that:

it may be appropriate for Contracting States to agree in bilateral negotiations that any relief from tax [provided by a tax treaty] should not apply in certain cases, or to agree that the application of the provisions of domestic laws against tax avoidance should not be affected by the Convention.27

Thus, the pre-2003 version followed the view that domes-tic anti-avoidance rules should be either included or

18. OECD Model Tax Convention on Income and on Capital: Commentary on Article 1 para. 9.2. (28 Jan. 2003), Models IBFD.

19. M. Schmitt, The Relevance of Amendments to the OECD Commentary for the Interpretation of Tax Treaties (Static or Dynamic Approach), in Funda-mental Issues and Practical Problems in Tax Treaty Interpretation p. 121 (M. Schilcher & P. Weninger eds., Linde 2008).

20. M. Lang, The Application of the OECD Model Tax Convention to Partner-ships A Critical Analysis of the Report Prepared by the OECD Committee on Fiscal Affairs p. 15 (Linde 2000).

21. K. Provodová, The Relevance of the OECD Report for the Interpretation of Tax Treaties, in Schilcher & Weninger, supra n. 19, at p. 151.

22. See para. 35 of the introduction to the OECD Model: Commentaries (2014), according to which: “Needless to say, amendments to the Articles of the Model Convention and to the Commentaries that are a direct result of these amendments are not relevant to the interpretation or application of previously concluded conventions where the provisions of those con-ventions are different in substance from the amended Articles. However, other changes or additions to the Commentaries are normally applicable to the interpretation and application of conventions concluded before their adoption, because they reflect the consensus of the OECD Member countries as to the proper interpretation of existing provisions and their application to specific situations.”

23. Schmitt, supra n. 19, at p. 121.24. G. Nolte, Report 3. Subsequent Agreements and Subsequent Practice of States

Outside of Judicial or Quasi-judicial Proceedings, in Treaties and Subsequent Practice p. 362 (G. Nolte ed., Oxford U. Press 2013).

25. OECD Model Tax Convention on Income and on Capital: Commentary on Article 1 para. 10 (11 Apr. 1977), Models IBFD.

26. Maisto, supra n. 14, at p. 339.27. OECD, supra n. 25, at para. 10.


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confirmed by tax treaty provisions. This approach only changed in 2003, when the OECD put forward the argu-ment that domestic anti-avoidance rules are used to deter-mine the facts that create the tax obligation. Therefore, since these changes in the Commentaries represent a new interpretation, there are good grounds to claim that they cannot be applied to older tax treaties. In any event, due to the lack of consensus on the legal status of the Commen-tary and its role in the interpretation of tax treaties, it has to be acknowledged that tax authorities and national courts may adopt different positions in this regard.

A more critical point relies on the fact that the United Kingdom shares the view of the OECD, set out in the Com-mentary on Article 1 of the OECD Model,28 in the sense that tax treaties do not affect the application of domestic anti-abuse rules, as the United Kingdom representatives did not record any observation against this interpretation. As a result, regardless of the legal relevance to be attributed to the Commentaries on the OECD Mode,29 it is clear that the United Kingdom, in interpreting its tax treaties, acts in good faith and in accordance with its unilateral stance, as it did not make any observation on the content of relevant paragraphs of the OECD Commentaries.30

The matter becomes even more complex when it is con-sidered that the UK tax law provides that its GAAR can be applied in a treaty context31 to counter any tax arrange-ments when it is reasonable to conclude, having taken all of the facts and circumstances into account, that a taxpayer intended to obtain a tax advantage. In this sense, HMRC has clearly stated that:

where there are abusive arrangements which try to exploit par-ticular provisions in a double tax treaty, or the way in which such provisions interact with other provisions of UK tax law, then the GAAR can be applied to counteract the abusive arrangement.32

Although the UK tax law extends its GAAR to a treaty context, this domestic legal provision may also give rise to a debate about whether it constitutes a treaty override,33 as it is a later domestic law that can be applied by HMRC in conflict with treaty provisions. A treaty override, in addi-tion to representing a breach of international law, also gives rise to serious consequences, as it undermines the legal certainty that tax treaties intend to develop. From an international law perspective, article 60 of the Vienna Convention (1969) establishes that:

28. Para. 9.2 OECD Model: Commentary on Article 1 (2014).29. It is not within the scope of this article to analyse the legal relevance of

the OECD Model: Commentaries (2014). In this context, see J.M. Mössner, Klaus Vogel Lecture 2009 Comments, 64 Bull. Intl. Taxn. 1, sec. 2. (2010), Journals IBFD. It is assumed here that the relevance to be attributed to the OECD Model: Commentaries (2014) should be considered on a case-by-case basis. With regard to this, see J. Sasseville, Temporal Aspects of Tax Treaties, in Tax Polymath: A Life in International Taxation Essays in Honour of John F. Avery Jones sec. 3, p. 46 (P. Baker & C. Bobbett eds., IBFD 2011), Online Books IBFD.

30. Paras. 9.2, 22.1 and 23 OECD Model: Commentary on Article 1 (2014).31. J. Schwarz, Schwarz on Tax Treaties, 3rd edn., p. 45 (Wolters Kluwer (UK)

Ltd. 2013).32. HMRC, General Anti Abuse Rule (GAAR) Guidance, para. B.53, available

at www.gov.uk/government/uploads/system/uploads/attachment_data/ file/399270/2__HMRC_GAAR_Guidance_Parts_A-C_with_effect_

from_30_January_2015_AD_V6.pdf.33. Schwarz, supra n. 31.

a material breach of a bilateral treaty by one of the parties entitles the other to invoke the breach as a ground for terminating the treaty or suspending its operation in whole or in part.

From economic and practical perspectives, non-resident taxpayers may lose their confidence in the behaviour of the other contracting state, as the tax treatment applying to their investments may suddenly be amended by a uni-lateral and uncoordinated action.

Additionally, as tax treaties are primarily concluded by sovereign states, it is clear that the provisions set out in tax treaties must be observed in view of the international public law principle of pacta sunt servanda, as set out in article 26 of the Vienna Convention (1969), which pro-vides that “every treaty in force is binding upon the parties and must be performed in good faith”. This fundamen-tal principle is supplemented by article 27 of the Vienna Convention (1969), according to which “a party may not invoke the provisions of internal law as a justification for its failure to perform a treaty”. Consequently, the contract-ing states embrace a commitment that binds them to not impose taxes on situations in which a tax treaty restricts their taxing rights. Under the international law, there are no possible justifications for a treaty override.34 As a result, even if, under the UK legal system, the doctrine of parlia-mentary sovereignty admits the enactment of domestic laws to override a treaty provision, such a breach of in-ternational law may be invoked by the other contracting state.35

In addition to this infringement, which may be questioned by the other contracting state, it should be emphasized that the domestic GAAR enacted by the United Kingdom and extended to the level of tax treaties does not represent a general legitimization of the DPT. The domestic GAAR may be used by HMRC to counter tax advantages arising from tax arrangements that are abusive, but it does not legitimate the imposition of the DPT in any circumstances, without demonstrating a practice of abusive tax arrange-ments by a taxpayer.

It is also important to note that the fictitious character-ization of a PE on the basis of a domestic anti-abuse rule without the support of the wording in the tax treaty may result in double taxation, as the residence state only grants a credit or an exemption in relation to the taxes levied in accordance with the distributive rules of a tax treaty.36 Even if the United Kingdom were to apply its domestic GAAR on the basis that a taxpayer intentionally avoided the characterization of a PE, the other contracting state could hardly adopt the same approach in granting double taxation relief in a treaty context. Consequently, the collec-tion of DPT by the United Kingdom could easily result in the double taxation of business profits, which is precisely what a tax treaty is designed to prevent.

34. P. Ribeiro de Souza, Tax Treaty Override, in Schilcher & Weninger, supra n. 19, at p. 255.

35. Schwarz, supra n. 31, at p. 42.36. M. Helminen, The International Tax Law Concept of Dividend, Series on

International Taxation vol. 36, pp. 105-106 (Kluwer L. Intl. 2010).




As a result, even if the position of the United Kingdom and its domestic GAAR is considered to consistent with the interpretation in the Commentaries on the OECDC Model, the truth is that the collection of the DPT would be contrary to the objective and purpose of a tax treaty. Con-sequently, in a treaty context, the levying of the DPT could only be justified in cases of proven abusive transactions.

Another aspect that must be addressed is the fact that various tax treaties concluded by the United Kingdom contain a general anti-abuse clause based on the principal purpose test (PPT). The PPT permits the investigation of the business purpose that guided a taxpayer in undertak-ing certain actions or transactions. The application of such a clause to justify the collection of the DPT would depend on a case-by-case analysis. With regard to tax treaties with PPT clauses, tax authorities can only reclassify an action or a transaction carried out by a taxpayer when one of the main purposes of the action or transaction is to prevent, reduce or delay the payment of taxes, without any other economic or business purpose. As a result, only actions or transactions undertaken with the sole or main purpose of avoiding taxes could be recharacterized by tax authorities.

Nevertheless, as stated in section 3., the DPT rules do not appear to require an investigation as to whether the sole or primary purpose of a taxpayer is to avoid taxes. In this context, it can be asked whether the DPT is really intended to counter cases in which MNEs artificially avoid the char-acterization of a PE in the United Kingdom without any other business purpose or, conversely, whether it is only a stringent mechanism to tax any sales or services per-formed in the UK domestic market, regardless of the char-acterization of a PE. In the latter case, even if the relevant tax treaty contains a PPT clause, it is possible to challenge the compatibility of the DPT with the equivalent to article 7 of the OECD Model in the tax treaty, given that the tax is levied on the profits obtained by a company resident in the other contracting state without the characterization of a PE in the United Kingdom.

Finally, it should be noted that, in the UK tax system, tax treaties only have effect insofar as domestic law so pro-vides. It may be debatable whether the Taxation (Inter-national and Other Provisions) Act (TIOPA) 2010 gives effect to tax treaties in relation to DPT, as this states that:

[d]ouble taxation arrangements have effect in relation to income tax and corporation tax so far as the arrangements provide ... (b) for taxing income of non-UK resident persons that arises from sources in the United Kingdom.37

Although the DPT cannot be considered to be income tax or corporation tax under the UK domestic tax law, it is

37. UK: Taxation (International and Other Provisions) Act (TIOPA) sec. 6(2)(b) 2010.

undeniable that a tax treaty validly concluded is binding from an international law perspective. For this reason, the other contracting state may challenge the breach of the provisions of a tax treaty by the United Kingdom given the introduction of the DPT. This may result in a tax treaty being terminated or suspended under international law.

5. Conclusions

The equivalent of article 2(4) of the OECD Model in the tax treaties concluded by the United Kingdom encompasses any identical or substantially similar taxes that are imposed after the date of the signature of a tax treaty. As the tax base of the DPT corresponds to the profits that would have been attributed to a PE, it can be considered to be a tax levied on elements of income.

As taxpayers have the right to choose the actions and transactions that they put into effect, the simple fact that the business model adopted falls within the definition of a PE does not authorize the collection of a similar tax, in contradiction to the international obligations assumed in a tax treaty. Consequently, the levying of the DPT should be restricted to cases where HMRC can clearly demonstrate the artificiality of the legal structure used by a taxpayer. In addition, if the structure used by the taxpayer has an unintended result in light of the traditional definition of a PE, the United Kingdom should renegotiate its tax treaties to amend the definition of a PE, instead of imposing a new tax.

Although UK tax law provides that its GAAR can be applied in a treaty context, such a breach of international law through a treaty override may be invoked by the other contracting state to terminate the tax treaty. In addition, the fact that the UK domestic GAAR may be used by HMRC to counter artificial tax arrangements does not legitimate the levying of the DPT in any circumstances, without proof of abuse.

Finally, despite the fact that, within the UK legal system, tax treaties only have effect insofar as the domestic law so provides, it is undeniable that a tax treaty validly concluded is binding from an international law perspective. Consequently, the other contracting state may challenge the breach of the tax treaty by the United Kingdom arising as a result of the introduction of the DPT.
