ROLE AND VALUE OF DOUBLE TAX AGREEMENTS IN THE PACIFIC ENVIRONMENT. Lee Burns *

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1 ROLE AND VALUE OF DOUBLE TAX AGREEMENTS IN THE PACIFIC ENVIRONMENT INTRODUCTION Lee Burns * In a paper entitled VAT in Pacific written in 2006, I observed that the Pacific is one of the few regions in the world where VAT is not widely used as a revenue raising instrument. 1 A similar observation may be made about double tax agreements ( DTAs ), namely that they are not widely used as a means of coordinating tax laws (particularly, income tax laws). The only PFTAC member countries that have DTAs currently in force are: Fiji (8 comprehensive DTAs and 1 international transport DTA), Kiribati (2), Marshall Islands (1 international transport DTA), PNG (8) and Solomon Islands (1). In addition, Cook Islands has recently negotiated a DTA with New Zealand, but it is not yet in force. In recent years, primarily through the work of the OECD, there has been an increased interest in the entering into of exchange of information agreements ( EIAs ) as a means of countering international tax avoidance and evasion. The OECD recently reported that, since 2000, over 80 EIAs have been entered into 2. Indeed, it was announced by the OECD prior to the meeting of the OECD Forum on Transparency and Exchange of Information in Los Cabos, Mexico last week that more than half of these agreements have been entered into in the last ten months. Indeed, it is expected that a significant number of further EIAS were agreed at that meeting. The only EIA that has been entered into in the Pacific as part of the recent work of the OECD is between New Zealand and the Cook Islands, although it is not yet in force. There is also an EIA between the United States and Marshall islands, which was part of an earlier information exchange project undertaken by the US in the 1980s. This paper will look at the purpose of DTAs and EIAs and exam their advantages and disadvantages for Pacific Island countries ( PICs ). EXISTING DTAs IN THE PACIFIC The following DTAs are currently in force in the Pacific. Fiji has comprehensive DTAs with Australia, Japan, Korea, Malaysia, New Zealand, PNG, Singapore and the UK. It also has an international transport agreement with the US. There was also a DTA with Switzerland that has been terminated. Kiribati has DTAs with Australia and the UK (old). Old DTAs with Denmark, Norway and Sweden have been terminated. PNG has DTAs with Australia, Canada, China, Fiji, Korea, Malaysia, Singapore and the UK. DTAs have been negotiated with Germany and Indonesia but are not in force. Solomon Islands has an old DTA with the UK. Old DTAs with Denmark and Norway * Lee Burns is a Professor in Taxation Law, Faculty of Law, University of Sydney. Lee can be contacted on l.burns@usyd.edu.au. Lee Burns L. Burns, VAT in the Pacific, in R. Krever & D. White (eds), GST In Retrospect and Prospect, Thomson, OECD, Overview of the OECD s Work on Countering International Tax Evasion: A Background Information Brief, OECD, Paris, July 16, 2009

2 2 have been terminated. Cook Islands has negotiated a DTA with New Zealand but it is not in force. Marshall Islands has an international transport DTA with the US. As can be seen from this summary, the only DTA between PICs is the Fiji-PNG DTA. This is not surprising given the level of trade and investment between PICs. WHAT IS A DTA? A DTA is an international agreement between two countries. The parties to a DTA are referred to as Contracting States. Like with other treaties, a DTA is subject to the general law on treaties as codified in the Vienna Convention on the Law of Treaties. DTAs usually relate to the income tax, although there are some DTAs applicable to other taxes, such as gift, estate and inheritance duties, social security taxes, and superannuation (including tax). As their name implies, DTAs are bilateral agreements. There are some multilateral tax treaties. The two most widely known are the Andean Pact 3 and the Nordic Convention 4. Both these treaties are regionally based reflecting commonalities in the design of the income tax among the Contracting States. Generally, a DTA will be comprehensive in coverage, although there are examples of DTAs with limited coverage. The most common example of a limited coverage DTA relates to international transport. There are two examples in the Pacific the international transport agreements between Fiji and the US and between the Marshall Islands and the US. PURPOSES OF A DTA The purposes of a DTA is usually set out in the preamble to the DTA, which commonly states that the purposes of the DTA are the avoidance of double taxation and the prevention of fiscal evasion. While usually not stated in the preamble, a third purpose of DTAs is non-discrimination. Avoidance of double taxation There are a number of ways in which double taxation can arise. Residence/source conflicts Most commonly, double taxation arises through the combined operation of the residence and source principles. Under the residence principle, residents of a country are taxed on their worldwide income and, under the source principle, nonresidents are taxed on their domestic source income only. Thus, a resident of Country A with business or investment activities in Country B, will be liable to tax on the income arising from the activity in Country B under the source principle and in country A under the residence principle. DTAs may resolve this conflict in one of three ways 3 The Contracting States are Bolivia, Colombia, Chile, Ecuador, Peru and Venezuela. 4 The Contracting States are Denmark, Faroe Islands, Finland, Iceland, Norway and Sweden.

3 3 (1) By requiring the residence country to give tax relief for the source country tax. There are two main forms of double tax relief that may be provided for under DTAs: the residence country may be obliged to give a credit for the source country tax against the residence country tax on the income (referred to as a foreign tax credit ); or the residence country may be obliged to exempt the income from tax. (2) The DTA may provide for residence country only taxation of the income. In other words, the DTA precludes the source country from taxing the income. This can occur, for example, with business profits. Under a DTA, a source country can tax only if the business profits are attributable to a permanent establishment in the country. This may exclude source taxation imposed under domestic law either because the DTA definition of permanent establishment is narrower than the definition in domestic law or domestic taxation is based on different rules such as place of contract regardless of whether or not there is a permanent establishment. (3) The DTA may provide for source country only taxation of the income. In other words, the DTA precludes the residence country from taxing the income. This is much less common under DTAs. There may be cases under the government service article when source country only taxation applies. This differs from the exemption method of double tax relief as the DTA will explicitly exclude the residence country s right to tax in relation to a particular specified item of income. In the early part of the twentieth century, (1) was the main way that DTAs solved the residence/source conflicts as residence countries did not always provide unilateral relief 5 from international double taxation. It is the norm for countries to provide unilateral relief and today this would be the main way that residence/source conflicts are resolved. In some cases, a DTA may provide greater relief than under domestic law the DTA provides for an exemption when the normal relief under domestic law is a foreign tax credit. Apart from that case, though, it may not be necessary for a taxpayer to resort to a DTA to obtain credit or exemption relief. Consequently, if comprehensive double tax relief is provided for under domestic law, a DTA may be relevant only when (2) or (3) apply. This means that today a DTA may be seen as more an instrument for the inter-nation sharing of revenues arising from a particular cross-border business or investment activity as between the residence and source countries. The basic structure of DTAs is to generally permit unlimited residence country jurisdiction to tax and either limit or exclude source country taxation. As explained below, this is done on an item-by-item of income basis. In broad terms, the source country has full taxing rights over active income (business profits and employment income) and has limited or no taxing rights in relation to passive income. The source country s right to tax active income, however, is dependent on the taxpayer having a sufficient economic connection to the jurisdiction. In the case of business profits, this 5 Unilateral relief means relief provided for in a country s domestic tax law (ie., it is provided unilaterally rather than bilaterally under a DTA).

4 4 is achieved through the requirement that the taxpayer conduct business in the source country through a permanent establishment. In the case of employment income, this is achieved by requiring the taxpayer to physically perform the employment in the source country. If the source country is permitted to tax under the DTA, then the residence country must provide relief from double tax, but, as observed above, this may be provided unilaterally. Residence/residence conflicts While it is now the international norm for countries to tax residents on worldwide income, there is not universal agreement as to how residence is defined. For individuals, two common methods are used to determine residence (1) Facts and circumstances approach having regard to all the facts and circumstances, a judgement is made as to whether a taxpayer has a sufficiently strong personal connection to the jurisdiction as to be regarded a fiscal resident of the jurisdiction. In Anglo countries, this is usually articulated in the legislation through the word resides and requires balancing a number of factors, including the location of the individual s home, physical presence in the jurisdiction, and personal and economic connections to the jurisdiction. (2) Days present approach an individual is a resident of a jurisdiction if they are physically present in the jurisdiction for a specified number of days (usually 183 days) in the tax year or, alternatively, in any period of 12 months beginning or ending during a tax year. This may be either an absolute rule or a presumptive rule. If it is a presumptive rule only, a taxpayer can avoid residence by showing a closer personal connection to another jurisdiction. Indeed, countries will often apply both methods in their domestic law. In practice, for an individual that may be posted abroad for 1-2 years, the reality is that it is easier to gain a new residence under the days present approach than it is to lose residence under the facts and circumstances approach. Thus, an individual working abroad may be a dual resident (ie., a resident of both their home and host countries) and as such potentially liable for tax on worldwide income in both countries. For companies, there are also two common methods used to determine residence (1) Place of incorporation a company is resident of the country in which it is incorporated. (2) Central management and control a company is resident of the country in which its central management and control is located. In the Anglo context, this is where the superior directing authority of the company is located. Based on case law, the superior directing authority of the company is usually exercised by the board of directors and, therefore, the company has its central management and control where meetings of directors take place. Again, countries will often use both methods in their domestic law. Consequently, it is possible that a company incorporated in one country but with its central management and control in another country will be a resident of both countries. It is

5 5 also possible that a company may have its central management and control divided between two countries and, as a result, be resident of both countries. A DTA is really the only effective way that a residence/residence conflict may be resolved. The residence article in a DTA will include tiebreaker rules that treat a person who is resident of both contracting states under each state s domestic law as a resident of one only of the states for the purposes of the DTA. Source/source conflicts Similarly, while it is the international norm that countries can tax non-residents on income sourced within their jurisdiction, there is no internationally agreed set of source rules for this purpose. Instances of source/source conflicts can be found for almost all classes of income. For example, some countries may regard business profits as sourced within the jurisdiction if the profits are attributable to a permanent establishment in the jurisdiction, while other countries may regard business profits as sourced in the jurisdiction if the place of contract is in the jurisdiction. Another example is royalties some countries may regard royalties as sourced in the jurisdiction if the underlying property giving rise to the royalty is used in the jurisdiction, while other countries may regard it as sourced in the jurisdiction if the royalty is paid by a resident of the jurisdiction. Again, a DTA is really the only effective way that a source/source conflict can be resolved. The taxing rights specified in a DTA effectively set out a uniform set of source rules that are then applied by both countries overriding any conflicting domestic rules. For example, under a DTA, attributable to a permanent establishment is effectively the source rule for business profits, place of performance is effectively the source rule for employment income, residence of the payer company is effectively the source rule for dividends, and so on. Conflicts of qualification A conflict of qualification arises when two countries apply different rules on the characterisation of income resulting in different tax treatment. For example, one country may characterise the rent arising on a chattel lease as royalties (with residence of the payer as the source rule) and another country may characterise it as business profits (with attributable to a permanent establishment as the taxing rule). A DTA can resolve this by including agreed definitions of particular income types, such as royalties, interest and dividends. Measurement disputes Double taxation can arise if different countries take different views on the measurement of income source in the jurisdiction. This can occur particularly in the application of transfer pricing rules. DTAs can resolve this through the mutual agreement procedure under which the two tax administrations can negotiate an agreed outcome.

6 6 Different taxing instruments applicable to the same income There are some classes of income in respect of which countries may use different taxing instruments, such as employee fringe benefits. The value of a fringe benefit is usually taxed to the employee under the normal income tax. However, in recent years, some countries (starting with New Zealand and Australia) tax the value of fringe benefits to the employer under a separate taxing Act. This can lead to taxing mismatches. Suppose Country A taxes fringe benefits under the normal Income Tax Act to the employee and country B taxes fringe benefits under a Fringe Benefits Tax Act ( FBT ) to the employer. Suppose further that a resident of County A is posted for a short period (say 6 months) to Country B and part of the remuneration in Country B includes benefits (such as housing and a car). The benefits are taxed in Country B to the employer under the FBT and the employee (as a resident of Country A) is taxed in Country A on the value of the benefits. Thus, the value of the benefits is double taxed, but under different taxing instruments and to different persons. Country A may not give relief for Country B s FBT on the benefits because it has been imposed under a different taxing instrument (which Country A may not regard as an income tax) on a different taxpayer. A DTA has the potential to resolve this conflict through Countries A and B agreeing a common tax treatment of fringe benefits. Prevention of Fiscal Evasion It is a rule of private international law that a country does not recognise the tax laws of another country. This means that there is no extra-territorial application of a country s tax laws. Consequently, for example, Country A s revenue authority cannot use its investigations powers in Country B; nor can Country A s revenue authority rely on the investigations powers in Country B s revenue law. The same applies to collection powers. Country A s revenue authority cannot rely on the debt recovery process in Country B to collect any outstanding Country A tax. This puts a revenue authority at a disadvantage as compared to multinational taxpayers. The revenue authority is limited to operating nationally while a multinational can operate globally. A DTA offers the opportunity for revenue authorities to provide for mutual co-operation in the enforcement of taxes. The traditional way that this has been done under DTAs is through the exchange of information. In recent times, assistance has extended to the recovery of unpaid tax. These provisions allow revenue authorities to collect information and taxes that they would not otherwise be able to do so because of territorial limits on their tax laws. Non-discrimination While not normally mentioned in the preamble, DTAs also provide for a principle of non-discrimination. In general terms, a Contracting State must not subject residents of the other Contracting State to more burdensome taxation than that applicable to its own residents.

7 7 BENEFITS OF A DTA It was stated above that the basic structure of DTAs is to generally permit unlimited residence country jurisdiction to tax and either limit or exclude source country taxation. Source country taxation may be excluded in relation to active income through the requirement of a minimum economic connection with the jurisdiction, such as a permanent establishment for business profits or minimum number of days of presence in the jurisdiction in the case of employment income. Similarly, source country jurisdiction may be excluded in the case of passive income through a zero rate (royalties) or, if source taxation is permitted, a limit may be imposed on the rate of tax. The tax that is not collected by the source country may then be collected by the residence country. As a country is both a residence and source country, the entering into of a DTA means that a country gives up source taxation in return for greater residence taxation. If the trade and investment between the two countries is roughly equal, in entering into a DTA, the Contracting States are, in effect, trading away sourcing taxing rights in return for greater residence taxing rights. In other words, what a country loses in giving up source taxing rights, it gains in increased residence taxing rights. Consequently, the effect of a DTA is largely neutral in that a Contracting State will collect more tax from its residents but less tax from non-residents. However, the situation is different if the trade and investment flows are not equal as is the case in DTAs between a developed and a developing country. By entering into a DTA, a developing country is giving up source taxing rights without any significant increase in residence country taxing rights. Indeed, a DTA can effect a transfer of revenue from the developing country (as source country) to the developed country (as residence country). What then are the advantages for developing country in entering into a DTA with a developed country? The main advantage is that a DTA may be an important instrument for encouraging foreign investment. Because, a DTA sets out a Contracting State s taxing rights as source country, it provides investors from the other Contracting State with a degree of certainty as to how their investment will be taxed. Generally, it is more difficult to amend a DTA than the domestic tax law and it would be a major political act to override or terminate a DTA. Similarly, as indicated above, the non-discrimination article in DTAs provides investors who are resident of the other Contracting State with a guarantee against discriminatory tax treatment. Further, as a DTA is based on the developed international norms applicable to the taxation of cross-border income, the entering into a DTA is a signal internationally that a country is prepared to play by the accepted international tax rules. If a developing country uses tax holidays to attract foreign investors, the other Contracting State (being a developed country) may be prepared to agree to tax sparing relief being provided for in the DTA. In broad terms, under a tax sparing relief provision, a residence country is prepared to treat the foreign tax that has been spared under the tax holiday as if it had been paid. This is particularly relevant for the foreign tax credit and means that the investor can obtain a credit for the tax spared. In the absence of such a provision, the tax that the developing country gives

8 8 up through the holiday may be collected by the developed country that is the home country of the investor. Finally, the administrative co-operation provisions in a DTA provide a revenue authority with greater enforcement and collection powers. These are good reasons for PICs to enter into tax treaties. Indeed, the loss in source taxation may be limited through the DTA negotiation process, particularly if the UN Model is followed (discussed below). However, care must be taken in choosing a DTA partner. Negotiating a DTA can take a long time, often 1-2 years. If done properly, it involves a significant investment in resources as the negotiating team must become familiar with the other country s tax law. For this reason, it is important that a developing country limits its DTA negotiations to its main trading and investment partners. There is little point in negotiating a DTA with a country in respect of which there is limited nor trade and investment. Indeed, it can be dangerous to do so, as it may simply facilitate treaty shopping, particularly if low rates on passive income are agreed because of a belief that it does not matter given the low levels existing investment. Multinationals are very adept at treaty shopping (ie. using DTA networks to funnel investment into countries to take advantage of low tax rates that otherwise would to apply). For South Pacific countries, Australia and New Zealand are obvious DTA partners given the level of trade and investment coming from those countries, and also the level of Islanders working in Australia and New Zealand. As stated above, the only DTA between Pacific Island countries is between Fiji and PNG. While there may be good political reasons for Pacific Island countries to negotiate DTAs among themselves, there is probably little to be gained economically from such DTAs. DTAs and Income Tax Reform As stated above, because it takes time and resources to negotiate a DTA, it is suggested that PICs focus their DTA negotiations on their major trading partners, including keeping these DTAs up-to-date through Protocols as the tax laws of the two countries are reformed. There is little to be gained by PICs in putting scarce resources into negotiating a comprehensive DTA network. Indeed, such a network is not going to happen overnight - Australia and New Zealand have taken thirty to forty years to negotiate their current DTA networks. While there are good political and economic reasons why a developing country would negotiate a DTA with its main trading partners, the reality in the global economy today is that foreign investment can come from many different sources. It is suggested that the best way to accommodate this is to internalise into domestic law the basic taxing rules in DTAs. This limits the differences in tax treatment that can arise for investors from DTA countries as compared to investors from other countries. Indeed, this is the approach that was taken with the new Tongan Income Tax Act. The law uses the permanent establishment concept as the basis for taxing business profits, it includes definitions consistent with those in DTAs (such as for royalties), and has relatively low rates of withholding.

9 9 Use of Model DTAs Most DTAs are based on the OECD Model DTA. This Model has its origins in the work undertaken by the League of Nations after the First World War. Part of the League s mandate was the removal, so far as possible, of all economic barriers and the establishment of equality of trade conditions among nations so as to improve global welfare. The removal of double taxation was part of this mandate. Over a nearly twenty year period, the League s Fiscal Committee worked on preparing model DTAs. When the League was finally dissolved in the mod-1940s, it had produced two comprehensive model DTAS the Mexico draft agreed in 1943, which had strong source country taxing rights and the London draft agreed in 1946, which had strong residence taxing rights. The difference in the models reflected the different interests of developing and developed countries. It was initially thought that the successor to the League, the United Nations, would continue this work, including agreeing a single model that would accommodate the interests of both developing and developed countries. However, this was not to be. While the work of the League was seen as essentially technical, the work of the UN became political. Unable to resolve the differing interests of developing and developed countries, the United Nations vacated the field of taxation in the 1950s. Given the differences that emerged between capital exporting and capital importing countries in early UN debates on taxation matters, it is not surprising that further developments on international tax took place within the framework of a body whose members had common interests, namely the OECD. The OECD was established as a forum to discuss, develop and perfect economic and social policy. A condition of membership is commitment to a market economy and pluralistic democracy. While the original membership was confined to developed countries, in recent years some emerging and transition economies have been admitted as members (Mexico (1994)), Czech Republic (1995), Hungary, Poland and Korea (1996), and the Slovak Republic (2000). In 1963, the OECD s Committee for Fiscal Affairs published a draft Double Taxation Convention on Income and Capital (and commentary) ( 1963 OECD Model ). Not surprisingly given that the member countries at the time were developed countries, the 1963 OECD Model was largely based on the London Model. The Model was revised in 1977, 1992 and 1995, and since then has been published on a looseleaf basis to facilitate regular revisions of the Model and commentary. OECD Member countries meet and exchange information through committees, one of which is the Committee on Fiscal Affairs. This Committee brings together treasury and tax officials to discuss tax policy and administration. The work of the Committee is carried out by Working Parties that comprise experts largely drawn from member countries. Currently, there are five active Working parties, including Working Party 1, which deals with tax treaties, and Working Party 6, which deals with the taxation of multinational enterprises (particularly transfer pricing). Working Party 1 has done an extraordinary amount of work on treaty policy over the last ten or fifteen years. This work has been reflected largely in substantial amendments to the commentary to the OECD model.

10 10 The emergence of new nation states in the 1960s, particularly in Africa, eventually resulted in the UN re-entering the field of international tax. These new nation states were not prepared to enter into tax treaties based on the 1963 OECD Model as that Model strongly favoured capital exporting countries. The UN Secretary General established the Ad Hoc Group of Experts in 1967 to look at the issue of tax treaties between developed and developing countries. The Ad Hoc Group published a Manual for Negotiation of Tax Treaties between Developed and Developing Countries in 1979 and a Model Double Taxation Convention between Developed and Developing Countries ( UN Model Treaty) in While closer to the Mexico draft, the UN Model did not go as far as to articulate primacy of source taxation as was the case under the Mexico draft. The UN Model contemplated a limit on source taxation of passive income but (unlike with the OECD Model) did not specify a rate leaving this to negotiation between the treaty partners. Also, the UN Model included a broader definition of permanent establishment thereby expanding the scope for source taxation of business profits. Given that the UN Model is a model tax treaty between developed and developing countries, it is not surprising that it did not go as far the Mexico draft as it needed to take account of both parties interests. Importantly, the UN Model follows the basic structure of the OECD Model. Indeed, the UN Model is not really a separate model treaty, but rather the OECD model with some important variations to expand source taxation. While the UN Model was never the subject of a formal resolution of the UN, it has had a significant influence in the development of tax treaties between developed and developing countries. Many developed countries (including Australia) have been prepared to largely follow the UN Model in their negotiations with developing countries. In 1980, the Ad Hoc Group of Experts was renamed the Ad Hoc Group of Experts on International Co-operation on Tax Matters and membership was increased from 20-25, comprising 10 tax administrators from developed countries and 15 from developing and transition countries. However, until recently, the Ad Hoc Group played only a minor role in the development of international tax policies. While the OECD Model was updated several times during the 1990s, it was not until 2001 that a revised version of the UN Model was produced. However, this was largely reactive to changes in the OECD model. Since then, however, the UN has been much more active on international tax matters. In 2004, the Ad Hoc Group was again renamed, this time as the Committee of Experts on International Co-operation on Tax Matters. The Committee met in 2005, 2006 and 2007, but, again, its work has been largely reactive to the work done on international tax by the OECD. Nevertheless, the ongoing work of the UN on tax treaties is important for developing countries, including PICs. In a negotiation between a developed and developing country, the areas of requiring negotiation are likely to be reflected in the differences between the OECD and UN Models. The advantage of the Model DTAs is that they allow the two Contracting States to focus their negotiations on these areas of difference and simply agreeing the terms of the OECD Model for the other clauses of the DTA. The main areas of difference will be the definition of permanent establishment, the scope of the business profits article, the rate limits on dividends, interest and royalties, and the short-term employment exception. It is important, though, that the terms of the tax law of two Contracting States are carefully considered in the negotiations so that any possible mismatches are resolved in the DTA. For example, in a negotiation with

11 11 Australia and New Zealand, agreement should be reached on how the FBT will apply to cross-border flows of labour. Relationship Between DTAs and Domestic Law This is essentially an issue of constitutional law. In Anglo countries, it is usually the case that a DTA is given legal effect by being enacted as part of domestic law. There may then be a provision in the domestic tax law that gives priority to a DTA in the case of any conflict between the terms of a DTA and domestic law. However, as this priority is in an ordinary law of Parliament (and not the Constitution), the principle of parliamentary sovereignty means that a DTA can always be overridden by a later law of Parliament but only if the later law expressly provides for such override. In the absence of such override, the DTA priority will prevail. As stated above, a DTA largely sets out the limits on a Contracting State s right to tax as source country. However, the fact that a DTA permits source taxation does not automatically mean that there will be taxation. The tax liability must be imposed by domestic law as a DTA does not itself impose tax. For example, article 22 of the Model DTAs provides for source taxation of certain capital (as opposed to capital gains) located in a Contracting State. If there is no capital tax under the domestic law of one of the Contracting States, then the capital article will have no legal effect for that State as source country. Consequently, the legal effect of a DTA is permissive only. It sets out the boundaries of source taxation, but that taxation must be provided for under domestic law. Importantly, this means that the analysis of the application of a DTA by a Contracting State to a transaction involves two steps. The first step involves determining the tax treatment under domestic law of the Contracting State. If there is no taxation under domestic law, then normally it would not be necessary to have regard to the DTA. If there is taxation under domestic law, then regard must be and to the DTA to determine whether it excludes or in some way limits that tax. In negotiating a DTA, it must be remembered that a Contracting State is both a residence and source country, although as stated above, developing countries are mainly source countries. In treaty negotiations, a Contracting State needs to consider the position of its residents in the other Contracting State. Returning to the example of Article 22 of the OECD Model, it is not uncommon for a Contracting State to have as its negotiating position that because it does not impose a capital tax under its domestic law it is not necessary to include the capital article in its DTA. However, if the other Contracting State has a capital tax (such as is the case in European countries), taking that position may work to the detriment of its residents if they own capital in that other State. If the capital article is not included in the DTA, the Contracting State has full taxing rights over capital owned in that State by residents of the other Contracting State. In these circumstances, it would still be appropriate for a Contracting State to negotiate for the inclusion of the capital article even if it does not have a capital tax as the inclusion will benefit its residents if they own capital in the other Contracting State. Of course, if both countries do not have a capital tax, there would be no need to include the capital article. Structure of DTAs

12 12 Consistent with source taxation generally, DTAs are schedular in nature. The DTA divides income into a number of categories with taxing rules specified for each category. Income is divided into the following categories (following the OECD Model DTA numbering) * Business income - business profits (Article 7) income from independent personal services is now dealt with in Article 7 as just another form of business income. Previously, it was dealt with separately in Article 14 and a large majority of existing DTAs will still include Article international transport (Article 8) * Services income - employment income (Article 15) - directors fees (Article 16) - artistes and sportspersons (Article 17) - pensions relating to past employment (Article 18) - government service (Article 19) - students (Article 20) * Passive income - rent or royalties from real property (Article 6) - dividends (Article 10) - interest (Article 11) - royalties (Article 12) - capital gains (Article 13) * Other income - Article 21 deals with any income not covered by the other Articles. As such, it operates as a residual category of income and is necessary because of the schedular nature. Some examples of income covered by Article 21 of the OECD Model DTA are - non-employment based retirement income

13 13 - annuities and income arising under life products - child support payments - gambling winnings - damages payouts, other than as business or employment income - income arising under an innovative financial instrument when there is no underlying debt claim (an underlying debt claim is necessary for the income to be interest under the OECD Model) other than as business income The schedular nature of a DTA means that it is important to first characterise the income to determine which article applies. Once the income is characterised, then the taxing rule applicable to that class of income is applied.