Tax Treaty Series

ITQ T-

074

January 29, 2021

Question

ACo, a company resident in A, has conducted business with customers in B for 10 years.

ACo has always taken the position that it does not have a PE in B under the A/B treaty, and that therefore it is exempt from B tax on its profits. For that reason, ACo has never filed a B income tax return.

Following a recent tax audit, the B tax authorities have claimed that ACo has had a PE in B for all of the 10 years. The tax authorities have therefore issued a tax assessment to ACo (reflecting item (ii) below for 8 of the years) in regard to the 10 years.

Under B income tax law: (i) the "statute of limitations" (i.e. the time period in which the tax authorities may issue assessments for an income year) only starts to run from the time that the taxpayer files an income tax return for the relevant income year; and (ii) a non-resident taxpayer which fails to file an income tax return within 24 months after the relevant income year, is denied all deductions in calculating its taxable profits for that year. Item (i) applies to both residents and non-residents, but item (ii) applies to non-residents only.

Both items (i) and (ii) were introduced into the B law in 1970.

The A/B treaty, which was signed in 2005 (this is the first treaty between A and B), is identical to the 2000 OECD model treaty.

Does the treaty permit the tax assessment to reflect item (ii)?

Answer

Art. 7(3) (2000 OECD model) states that all of the expenses incurred for the purposes of the PE shall be deducted in determining the profits attributable to the PE.

However, in the 2008 Update, para. 30 was added to the OECD Comm.: Art. 7(3) does not deal with whether expenses, after being attributed to the PE by Art. 7(3), are deductible under domestic law – that is "a matter to be determined by domestic law, subject to [Art. 24]." The interesting issue is whether para. 30 (added in 2008) should be taken into account in interpreting the 2005 A/B treaty.

If it is taken into account, the conclusion would be that Art. 7 would not prevent the disallowance of the deductions.

However, Art. 24(3) requires that B's tax on ACo's PE shall not be less favourably levied than the tax levied on B-resident enterprises carrying on the same activities. Item (ii) under the B law appears to breach this requirement. That view is supported by para. 24(a) of the 2000 OECD Comm., which states that PEs must be accorded the same right as resident companies to deduct trading expenses.

Nevertheless, the US Tax Court has recently held (Adams Challenge case) that a similar rule to item (ii) does not breach either Art. 7(3) or Art. 24(3). Key to the court's decision is that the relevant rule was included in US domestic law many years before the treaty was signed – thus, the treaty partner was "on notice", and did not object. Also, the US does not accord supremacy to treaty provisions.

If B does accord supremacy to treaty provisions, IMHO: Art. 7(3) might not be breached, but Art. 24(3) should be breached.

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