Pakistan has evidenced as many as three tax laws since its independence. The respective Governments have negotiated many tax treaties during their tenure. As Tax treaties are sovereign documents signed by the sovereign states but promulgation of Income Tax Ordinance, 2001 and amendment of OECD/UN Model treaties – ambulatory approach - have risen as many doubts in the minds regarding the double taxation treaties signed with the sovereign states. This article is an endeavour to assess the basic concepts of tax treaties at the outset and interpretational problems of the tax treaties.
Nowadays, tax treaties are the most critical aspect of international tax legislation of most countries. Tax treaties may be bilateral – between two countries – or multilateral – between more than two countries without any limitation of number of countries involved. Most of these treaties are either based on OECD Model Treaty or UN Model Treaty. Both of these treaties are normally referred to as Model Tax Treaties. It is worthwhile here to note that UN Model Treaty includes some provisions that are not included in the OECD Model Treaty. The reason for including OECD Model and UN Model Treaties is that almost all the tax treaties are based on either of these.
OBJECTIVES OF TAX TREATIES
The broad objective of tax treaties is to facilitate cross-border trade and investment by eliminating the tax impediments to these cross border flows. Broad objective is normally reflected in the policies of the Government of Pakistan. However there are two operational objectives of bilateral tax treaties.
1. Elimination of double taxation
2. Prevention of fiscal evasion
Section 107 of the Income Tax Ordinance, 2001 revolves around the operational objective of tax treaties. Apart from the broad and operational objectives, there are several ancillary objectives and includes the following.
1. Elimination of discrimination against foreign nationals and non-residents,
2. Exchange of information between the contracting states,
3. Mechanism for resolving disputes arising from the interaction of tax systems, and
4. Certainty in the consequence of cross-border investment as the taxpayer knows that despite changes in thetax laws of the source country, the basic limitation in the treaty on the source country’s right to tax will prevail.
TAX TREATIES
Tax treaties are agreements between sovereign nations. Article 2 of the Vienna Convention on the law of treaties provides that a treaty is an international agreement, in one or more instruments by whatever name called, concluded between states and governed by international law. These tax treaties confer rights and impose obligations on the contracting states.
In Pakistan, the tax treaties do not confer rights on citizens or residents of the contracting state unless the provisions of the treaty are in accordance with section 107 of the Income Tax Ordinance, 2001. Therelationship between tax treaties and domestic legislation is a complex subject. The basic principle is that the treaty should prevail in the event of conflict between the provisions of Income Tax Ordinance, 2001 and a treaty.
In Pakistan, the central government is constrained by the constitutional mandate from entering into tax treaties that limit the taxing power, hence, the tax treaties in Pakistan apply only to national taxes – Income taxes, similar to Canada and USA. The tax treaties of Pakistan are complex in nature and sometimes impose tax in accordance with Income Tax Ordinance, 2001 and sometimes they limit the taxes. Section 107 provides for a ground to reconcile an apparent conflict between tax treaty and Income Tax Ordinance, 2001.
TREATIES - Revision and Overrides
Once a treaty has been adopted, it may be modified in minor or major ways by the mutual consent of thecontracting states. Normally, treaties are amended by entering into a protocol to the treaties. Under international law, an agreement designated as a protocol is simply a treaty under a different name, hence, it must be ratified under the rules applicable to treaties before it become effective.
As domestic laws are normally amended and interpreted frequently to respond to new circumstances – tax treaties are no exception. The proper remedy for a defective treaty provision is bilateral adoption of an appropriate amendment to the treaty but practically this process is a very long and slow process. Hence, sometimes the protocol takes a longer period than the treaty itself. Once one aspect of a treaty is opened for renegotiation, other aspects of the treaty become negotiable.
Tax treaties are updated without a formal amendment procedure through the interpretive process. For instance, the mutual agreement procedure authorizes the competent authorities of the two states to resolve issues of interpretation. In the tax treaties of Pakistan, Central Board of revenue and the ministry of finance are the competent authorities. Occasionally, some countries have passed legislation to modify or overturn the interpretation of a tax treaty given by a domestic court. Such legislation, adopted in good faith, may not violate a country’s obligation under its tax treaties. Often the country overriding its tax treaties will consult with its treaty partners to demonstrate good faith and to prevent misunderstanding.
Treaties are solemn obligations that should not be disregarded except in extraordinary circumstances. At the same time, Pakistan is amending its domestic legislation from time to time to keep it current and to clarify interpretative difficulties.
CONCEPT OF INTERPRETATION OF TAX TREATIES
The interpretation of tax treaties bears certain similarities to the interpretation of domestic tax legislation, for instance, meaning of the words, the context in which they are used and the purpose for which they are used generally important in interpreting both treaties and domestic tax legislation. However, there are several important differences.
1. Questions of interpretation are normally resolved by reference to the mutual intentions of both states.
2. Tax treaties are addressed to the both governments and taxpayers of both countries.
3. Tax treaties are often not drafted using the same definitions as used in domestic legislation.
4. Tax treaties are primarily relieving in nature instead of imposing taxes.
5. The influential OECD Model / UN Model and their commentaries have no counterparts in the context of domestic tax legislation.
A term has the same meaning under the domestic law if it is not defined in the tax treaty unless the context requires otherwise. This wording leads us to the customary international law. The interpretation of tax treaties is governed by customary international law – Vienna convention on the law of treaties. Even countries that have not signed the Vienna Convention may be bound by its provisions because those provisions represent a codification of customary international law, which is binding on all nations.
The basic rule of interpretation in article 31(1) of the Vienna Convention provides that a treaty shall be interpreted in god faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in light of its object and purpose. In addition, article 31(2)’s context includes
1. The text of the treaty,
2. Any agreements between the parties made in connection with the conclusion of the treaty; and
3. Any instrument made by one of the parties and accepted by the other party.
In furtherance, under article 31(3) subsequent agreements between the parties and subsequent practice with respect to the interpretation of the treaty and any applicable rules of international law must be taken into account together with the context.
However, under article 32 of the Vienna Convention, other material, referred to as supplementary means of interpretation, which include the travaux preparatoires [Preparatory work] of the treaty, are only to be considered to confirm the meaning established pursuant to article 31, or to establish the meaning if article 31 produces an ambiguous, obscure, absurd, or unreasonable result.
The OECD Model Treaty and commentary under Vienna Convention are important for the interpretation of tax treaties. However, their legal status under the provisions of Vienna Convention is unclear. One school of thought says that at first glance, they appear to be supplementary means of interpretation under article 32. If one agrees with this school of thought then they are relevant only to confirm the meaning otherwise established by the application of the principles of interpretation in article 31 or to establish the meaning if the meaning under article 31 is ambiguous, obscure, absurd, or unreasonable. However, the OECD does not intend for the commentary to have such a limited role.
At the outset of the commentary, it is stated that the commentary can be … of great assistance in the application and interpretation of the conventions and, in particular, in the settlement of any disputes. It is difficult, however, to justify including the commentary as part of the context of a treaty under article 31 of the Vienna Convention, especially if the treaty being interpreted was entered into before the commentary was revised or if one of the contracting states is not a member of the OECD and therefore had no part in the preparation of the commentary. However, the status of the OECD Model Treaty and Commentary under the Vienna convention is a controversial topic among international tax scholars. Apart from that, in treaty cases of all countries, the courts invariably give the Model Treaty and Commentary substantial weight; otherwise, income may be taxed twice or not at all.
It is the common principle of interpretation that tax treaties be interpreted the same way in both countries because otherwise income may be taxed twice or not at all. Assume that Mr. Motasim Bajwa is a resident of country A and who performs services in country B for the benefit of company C. The services result in the creation of some work product used by company C. Mr. Motasim receives a payment from company C that is characterized under the laws of country B as compensation for performing services country B. In contrast, country A characterizes the payment as a royalty for allowing company C to use Mr. Motasim’s work product. Under the tax treaty between the two countries, fees for personal services are taxable in the source state and royalties are taxable in the residence state. Under these circumstances, Mr. Motasim will be subject to double taxation unless the competent authorities of the two countries can resolve the matter. This example is the essence of famous case involving Pierre Boulez, a world renowned French conductor resident in Germany who received payments for conducting a series of concerts in United States.
In addition to the provisions of the Vienna Convention, tax treaties based on the OECD and UN Model Treaties contain an internal rule of interpretation. Article 3(2) of the OECD and UN Model Treaties provides that undefined terms used in the treaty have the meaning that they have under the domestic law of the country applying the treaty unless the context requires otherwise. Thus, the application of article 3(2) involves a three-stage process.
1. Does the treaty provide a definition of the term?
2. If the treaty does not provide a definition, what is the domestic meaning of the term?
3. Does the context of the treaty require a meaning different from the domestic meaning?
First step is not that as it appears as there are two types of definitions – inclusive and exclusive. An inclusive definition means that the term has its ordinary meaning plus the items that are specifically mentioned. On the other hand, an exclusive definition means that the term has the special meaning assigned to it in the foregoing definition.
For instance, some definitions in tax treaties are inclusive while others are exclusive. Article 3(1) (a) defines a person to include an individual, a company and any other body of persons. In contrast, the definition of the company in article 3(1) (b) is exclusive. Does article 3(2) apply to determine the ordinary meaning under domestic law of terms that are defined inclusively, such as persons?
Further, definitions in the treaty often contain terms that are undefined. For instance, the terms “individual” and “body of persons” in article 3(1) (a) are not defined. Do these terms take their meaning from domestic law by virtue of article 3(2)?
The determination of the meaning of a term under domestic law also may be difficult. Article 3(2) provides that the meaning of an undefined term under a country’s tax law prevails over the meaning under other domestic laws. An undefined term, however, may have more than one meaning for purposes of a country’s law. In this situation the domestic meaning that is most appropriate should be used into the context of the treaty.
It should also be noted that article 3(2) refers to the meaning of a term, not its definition, under domestic law. A term may not be defined for purposes of a country’s tax law, but it should have an ordinary meaning.
The final step in the application of article 3(2) is to consider if the context of the treaty requires the use of a different meaning of a term from the meaning under the domestic law. For this purpose, it is necessary to consider the alternative meanings for the term for purposes of the treaty and whether one of these meanings is more appropriate in the context of the treaty than the domestic law meaning. Matters that should be considered in this analysis include:
1. The ordinary meaning of the term as compared to the meaning under the domestic law;
2. The meaning of the term under the other country’s tax law;
3. The purpose of the relevant provision of the treaty; and
4. Extrinsic material – for instance, the commentary to the OECD Model Treaty or to the UN Model Treaty
However, there is an school of thought of international tax scholars, which argue that in applying article 3(2) - undefined terms should be given, if at all possible, a meaning that is independent of domestic law and that a domestic law meaning should be used only as a last resort.
Another school of thought of international tax scholars argue that article 3(2) contains a preference for domestic law meanings because such meanings are only displaced by a treaty meaning if the context requires otherwise.The use of word require, they argue, places a substantial onus on those seeking to justify a treaty meaning.
However, I am of the view that the words of article 3(2) do not establish any clear preference for domestic law meanings or treaty meanings for undefined terms. There is no strong policy reason for establishing any residual presumption in favour of a domestic or treaty meaning. The meaning of undefined terms in a tax treaty should be determined by reference to all of the relevant information and its entire relevant context.
Another important and controversial issue of interpretation in connection with article 3(2) of the OECD and UN Model Treaties is whether a term has its meaning under domestic law at the time that the treaty was entered into – Static approach – or its meaning under the domestic law as amended from time to time – ambulatory approach.
Article 3(2) of the OECD Model Treaty was amended in 1995 to make it clear that article 3(2) should be applied in accordance with the ambulatory approach. A similar conforming amendment was made to the UN Model Treaty in 2001. The ambulatory approach allows treaties to accommodate changes in domestic law without the need to renegotiate the treaty.
A drawback of the ambulatory approach is that it effectively permits a country to amend unilaterally its tax treaty with another country by changing certain parts of its domestic law. For example, an amendment to domestic law that significantly alters the bargain between the two countries and was not contemplated by both countries is equivalent to a treaty override.
It is worthwhile here to note that in some of the Pakistani double tax treaties CBR has used the wording the law as it stands at the time of signing of this treaty. This wording has raised as many questions as answers. Whether the ambulatory approach is applicable in the presence of this wording?
CONCLUSION
Basic concept of double tax treaties lies at the heart of ACCA syllabus of 2.3 paper of Pakistan. The tax treaties have broad, operational and ancillary objectives. The basic principle is that the treaty should prevail in the event of conflict between the provisions of Income Tax Ordinance, 2001 and a treaty. The basic rule of interpretation in article 31(1) of the Vienna Convention provides that a treaty shall be interpreted in god faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in light of its object and purpose. The next article will look at the detailed aspect of the some selected tax treaties and the important amendments required therein.
The author is an International tax advisor and teaches UK and Pakistani Taxation at various approved colleges of ICAP and ACCA. He is also a member of publication committee of ICAP. His articles on taxation and corporate law have been published in leading local and foreign newspapers and journals. He can be contacted at
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