Tax Treaty Series

ITQ T-

065

November 13, 2020

Question

The A/B treaty, which was signed and entered into force in 2005, is identical to the 2001 UN model treaty, with the rate specified in Art. 12(2) being 10%. A 10% rate is used in the royalties article in most of A's double tax treaties.

At the time the treaty was signed, A domestic law did not levy a withholding tax on outbound payments of equipment rentals, although it did levy a 15% withholding tax on all other outbound payments described in the definition of "royalties" in Art. 12(3) of the UN model.

In 2010, A changed its domestic law to levy a 10% withholding tax on outbound payments of equipment rentals which are paid to residents of jurisdictions with which A has a comprehensive double tax treaty - that would include residents of B. However, under A domestic law, the withholding tax does not apply to outbound payments of equipment rentals to recipients which are not resident in such jurisdictions.

In other words, a non-treaty resident is exempt from the withholding tax on equipment rentals.

BCo (a company resident in B) has leased an item of equipment to a resident of A, for use in A.

Does the A/B treaty permit the 10% withholding tax to apply to the equipment rentals which are paid to BCo?

Answer

1. Non-discrimination

A's withholding tax discriminates against residents of treaty countries, in favour of residents of non-treaty countries. However, none of the paragraphs in Art. 24 applies to this situation. In particular, it should be noted that Art. 24 is not a "most favoured nation" provision.

Thus, A's withholding tax on equipment rentals does not breach Art. 24.

2. General principle that treaties cannot increase tax liabilities

Some people assert that there is a general principle that double tax treaties cannot increase tax liabilities.

It is arguable whether there is such a general principle. However, even if there is, there is no breach of that principle here: A's withholding tax on BCo is levied by the A domestic law, not by the A/B treaty.

3. "Good faith" under Art. 26, Vienna Convention on the Law of Treaties

Art. 26 requires the parties to a treaty to perform it "in good faith".

Does A's withholding tax on residents of treaty countries, but not on residents of non-treaty countries, breach Art. 26?

IMHO: No – The A/B treaty permits A to levy a tax of up to 10% on residents of B in receipt of equipment rentals, and that is exactly what A's domestic law has done. The treaty has been performed in good faith.

4. Example and policy

Korea provides a good example of this type of withholding tax which discriminates against residents of treaty countries, in favour of non-treaty countries.

The policy for such a tax is this: the A/B treaty is the result of "horse-trading" by both countries. A's rights under the treaty were obtained by A for the "price" of it relinquishing some tax rights to B. Having so "purchased" its treaty rights, it would be foolish for A not to levy taxes up to those treaty rights.

In contrast, with a non-treaty country, there is no "purchase" element.

ITQ Disclaimer

This International Tax Quiz (ITQ) contains general information only, and none of International Insights Pte Ltd, its employees or directors is, by means of this ITQ, rendering professional advice or services. You use the content of this ITQ strictly at your own risk. You should not rely on all or any part of the content of this ITQ in making decisions to take action (including inaction) in regard to tax or other matters. Before making any decision or taking any action (including inaction) that may affect your tax position, your finances or your business, you should consult a qualified professional advisor. None of International Insights Pte Ltd, its employees or directors shall be responsible for any loss whatsoever sustained by any person who relies on the content of this ITQ.