THE ADVANCED DIPLOMA IN INTERNATIONAL TAXATION

December 2017

PAPER 1

SUGGESTED SOLUTIONS
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PART A

Question 1

The following is one possible schematic.

Introduction

 Some context: the MLI is the product of BEPS Action 15, which sought to bring about a
united and as coordinated an approach as possible to implementing changes in bilateral
tax treaties that would further the recommendations of the Final Reports of BEPS Actions
2, 6, 7 and 14.

 Explanatory Statement prepared by ad hoc Group and text adopted on 24 November

2016.

 Signing ceremony June 2017 with over 70 signatories.

 Purpose of the MLI: Action 15 was tasked with determining “innovative ways to
implement the measures resulting from the work on the BEPS action plan”.

 Structure: The MLI is divided into parts: Part 1: Scope and interpretation; Part 2: Hybrid
Mismatched (Action 2): Part 3: Treaty Abuse (Action 6); Part 4: Avoidance of a
Permanent Establishment Status (Action 7): Part 5: Improving Dispute Resolution (Action
14); Part VI: Arbitration; and Part 7: Final Provisions. Each substantive article (i.e. 3-17)
that does not reflect a minimum standard follows a similar structure:

- Details of how the BEPS Actions relate to the relevant article of the MLI.
- Compatibility clauses that define the relationship between the relevant article of
the MLI with the covered tax agreement (CTA).
- Reservation classes that define the reservation permitted with respect each article.
- Notification clauses reflecting: optional provisions; clarifications about existing
provisions within the scope of the relevant compatibility clauses.

 Part VI (article 18-26):

- Reflects the work of the Sub-group on Arbitration to develop provisions for

mandatory binding arbitration of mutual agreement.
- Reflects a minimum standard.
- Only applies where parties have expressly chosen to apply Part VI.
- Rules for compatibility are found in Article 26 MLI.
- Reservations can be individualised.

Main points

This section selects a number of provisions and analyses the extent to which they constitute
major or minor changes. Students can also consider the significance of the MLI at a broader
policy level. The USA has not signed the MLI. Other countries have agreed to (almost) all of
the available options, e.g. New Zealand. There is a view that the US’s failure to sign the MLI
does not undermine its impact but may show the weakness of the OECD as a leader of
international developments (Baker 2017).

Major impact

 Some estimates provide that the MLI will impact approx. 1,000 bilateral tax treaties
(OECD Secretary General Angel Gurria, 2017).

 Preamble: provides for the purpose of the MLI to be included in CTAs in order implement
BEPS measures and to ensure that existing agreements have as their purpose both the

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avoidance of double taxation but also that existing provisions are interpreted in such a
way that does not create opportunities for non-taxation or reduced taxation.

 Adding a multilateral instrument to the existing patchwork of bilateral treaties could

qualify as a “regime” change in the literature on international relations between national
states. (Broekhuijsen and Vording, 2016).

 The only major international tax multilateral instrument currently in force is

The Multilateral Convention on Mutual Administrative Assistance in Tax Matters:
Amended by the 2010 Protocol.

 Signing ceremony is a focal point for completion of first stage of BEPS project: Baker
2017.

 MLI is a new form of instrument in international tax relations. It offers a tool for
streamlined amendment of a large number for bilateral tax treaties: Baker, 2017.

 It is significant that the process has brought together countries at various stages of
development.

 It has taken on a momentum of its own, by providing a forum for discussions, serving as
a focal point for international public opinion, and building trust among participants.

 Some of the modifications to bilateral tax treaties may have far reaching consequences,
e.g. Article 7 on Tax Treaty Abuse, which reflects a “minimum standard” (Baker, 2017).

 Part VI covers improving dispute resolution and provides for a minimum standard. The
OECD released the first tranche of peer review reports on the implementation of the
minimum standard in this regard in late Sept 2017 (these later publications are not
examinable). It has been reported that approx. 30 countries have signed up to mandatory
binding arbitration.

Minor impact

 Applies to (CTAs) only even where a country has signed the MLI. India is reported as not
having included its tax treaty with Mauritius and that this and other non-CTAs may be
bilaterally negotiated (Business Line, 2017).

 Availability of options, reservations in Arts 3-17 MLI (see above).

 The number of options available even where no reservation is made.

 The extent of the MLI’s multilateralism is thin due to the need for bilateral co-operation in
at least a number of parts of the MLI. See Goldsmith & Posner (2003) who state that
“most multilateral treaties that are not purely hortatory are based on some form of
embedded bilateral cooperation … genuine multilateral cooperation ... is thin, in the
sense that it does not require nations to depart much, if at all, from what they would have
done in the absence of the treaty”.

Conclusion

 Perhaps consider the extent to which the adoption of the MLI will result in major/minor
changes to bilateral tax treaty networks as supported by their analysis in the “main points”
section above.

 There is a view that as the MLI does not address distributional aspects it will be met with
widespread support (Broekhuijsen and Vording, 2016).

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 The quote accurately encapsulates the pathway to a more coordinated approach to

policy and scope for continued uncertainty in the area of international taxation (e.g.
whether a South African pension constitutes a “qualified person” for the purposes of the
MLI; the scope of the principal purpose test: Broekhuijsen and Vording, 2016.

 The MLI cannot realistically be expected to fix all the issues created by the interaction of
large numbers of domestic tax systems. Brooks (2010) notes that “multilateral treaties
will not provide a panacea for the challenges of modern day international tax planning”
and that domestic systems and administrators need to be robust. There is a need for
agreement about a minim level of tax or some other kind of tax harmonization:
Broekhuijsen & Vording, 2016.

First tax treaty modifications are likely to enter into force in early 2018. There will be an
opportunity then to further reflect on the impact of the MLI.

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Question 2

This question provides students with an opportunity to discuss the permanent establishment
(PE) concept, while also making it clear why it is both a source taxation concept and a threshold
concept. This question also gives scope to discuss some of the problems associated with the
PE concept, as long as those problems can be traced back to its ‘artificiality’. Thus students are
required to understand the nature of the problems with the PE concept in order to effectively
filter their answer. It also presents an opportunity to discuss options for reform. Finally, students
are encouraged to discuss what kind of global tax system would negate the need for such a
source concept. One, but by no means the only, such system would tax the worldwide income
of residents and nothing else.

The following is one possible schematic.

Introduction

The current international tax regime permits a country to impose tax on the worldwide income
of residents and on the domestic-source income of non-residents. Where those non-residents
are multinational enterprises (MNEs), the means by which their domestic source income is
taxed is through a PE. The PE concept is used to establish the sufficiency of the economic
nexus between the MNE and the host/source state. Once there is a sufficient connection, the
host state can then assert taxing jurisdiction over the business profits allocation to the source
activity of that MNE.

The PE Concept – Source and Threshold

Source-based taxation works on the principle that non-residents may still be taxed on their
economic activity and capital gains within the host state’s borders, despite the fact they are
non-residents. The source country can claim priority over the residence state’s claims to
income, if the taxable entity participates in the economic life of the host state. So, what is the
minimum level of activity – the threshold – that an MNE can engage in before it becomes liable
for source-state taxation? The answer is found in the use of the PE concept.

The OECD MTC establishes fundamental criteria for determining if a PE exists:

 a fixed place of business (FPB);

 the FPB must be located in a certain territorial area: the ‘place-of-business test’ – the
existence of premises, machinery or equipment;

 the use of the FPB must last for a certain period of time: the ‘permanence test’ – the
location must be distinct and fixed with a certain degree of permanence);

 the taxpayer must have a certain right of use over the FPB; and

 the activities performed through the FPB must be of a business character, as defined by
DTAs and domestic tax law: the ‘business-activities test’ – (usually) personnel conducting
business in that place.

Under BEPS Action 7, there seems to be: a lowering of the PE threshold; less relevancy is
attached to practical thresholds; and an avoidance of bright line rules. As a result there may be
greater subjectivity in PE identification and profit allocation. However, some commentators
observe that the changes do not modify the nature of a deemed PE. Thus, in many cases,
additional profits attributable to ‘new’ PEs will be minimal.

Problems due to Artificiality

This section is based on Basu (2012).

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The PE concept prevails as the standard for the determination of tax jurisdiction for international
business income. However, it is a product of early trade practices and support for it is
deteriorating. The PE concept is a compromise. It sacrifices tax revenues in favour of
administrative efficiency.

Even before e-commerce, commentators opined that commercial practice had already largely
eroded the PE concept. A key problem in a modern context is that it does not “envision or
encompass the existence of a nexus between intangible business activities and foreign
markets”. Basu holds that:

“the fundamental concept underlying current OECD nexus and income attribution
rules, that income should be attributed to the location where the value is created,
is obsolete. For e-commerce companies, the nexus should not be based solely
on the location of manufacturing, research, marketing, and other wealth-creating
activities. Rather, the place of consumption should also give rise in some way to
a direct tax nexus. ... Due to this weakening connection between physical and
economic presence, the current definition of a PE, which largely relies on physical
manifestations of an economic presence, might give rise to anomalous results
and to violations of the tax principles”.

The OECD’s Task Force on the Digital Economy has been considering a number of options for
reform:

 modifications to the exemption from PE status;

 the creation of a significant digital presence PE;
 varieties of a virtual presence PE;
 withholding tax on digital transactions; and
 consumption tax options.

The French Task Force on Taxation of the Digital Economy argues that the activities of digital
companies lack ‘points of stability’ required to create a PE. They propose that PE encompass
a ‘permanent virtual establishment’ (PVE), under which a deemed PE arises once sales reach
a certain level. The conceptual basis being that providing a customer base creates the right to
tax. Does OECD MTC, Art.5, already cover a virtual PE? Hinnekens suggests it would operate
on the basis of continuous and commercially significant business activity, which is arguably
consistent with source taxation theory: a sufficient degree of participation in economic life.

A Sensible Global Tax System

What kind of global tax system would negate the need for the PE concept? An obvious
contender would be one that solely taxes the worldwide income of residents. Another, but less
obvious system, would be one that taxes the physical presence of foreign multinational
enterprises according to a fixed formula. For example, Elkins (2017) suggests that a host
country could combine “(a) a tax base that properly reflects the costs and benefits of hosting
the investment with (b) a fixed payment schedule”. He argues that such a tax structure would:

“prove more effective than income tax in attracting investment that would
contribute to the welfare of the host country’s residents, in deterring investment
that would constitute a net drain on its resources, in creating economic value by
appropriately allocating risk, and avoiding the agency costs inherent to an income
tax.”

Elkins argues that the primary justification for income tax is its conformity with ability-to-pay,
which is an attempt to tax wealth and mitigate inequality. This is irrelevant with regards
foreigners in general and PEs in particular, Distributive justice concerns only the members of a
society. Foreigners do not have a stake. Commutative justice, though, encompasses an MNE’s
obligations to a source country – and there is no reason to assume a linear or progressive
relationship between the value of the services provided by the host country and the MNE’s
income.

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A contrary theoretical perspective is, according to Hoffart (2007), that the “social contract” view
of source-based justification for taxation is based on the principle of cost and benefit theories
of taxation, which argue that taxpayers should pay the state for the cost of state-provided
services or in accordance with specific benefits received by the taxpayer.

Conclusion

Perhaps, the penultimate word can be left to the OECD (2013), which states that treaty rules
for taxing business profits:

“use the concept of [PE] as a basic nexus/threshold rule for determining whether
or not a country has taxing rights with respect to the business profits of a
nonresident taxpayer. … The [PE] concept also acts as a source rule to the
extent that, as a general rule, the only business profits of a non-resident that may
be taxed by a country are those that are attributable to a permanent
establishment.”

Perhaps, though, as some commentators suggest, income is simply not an appropriate tax base
in an international context.

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Question 3

This question provides students with an opportunity to discuss the principles of efficiency (and
equity) in an international context. Capital export neutrality and capital import neutrality are
principles based on efficiency and have been instrumental in influencing states in their provision
of tax relief. Students may also like to consider the principles of capital ownership neutrality,
national neutrality and market neutrality, and the attendant controversies. There is also scope
to discuss the single tax principle and the double non-taxation principle.

The following is one possible schematic.

Introduction

 Various principles have influenced international tax policy (ITP) making.

 Those principles revolve around the concept of neutrality.

 Neutrality is arguably a derivative of the principle that taxes should be efficient.

 The principle of equity also has a place in ITP.

 In an ITP context, equity is embodied by ‘inter-nation equity’ or ‘inter-jurisdictional equity’,

which is about a fair or equitable allocation of tax revenue across states. It refers to the
equitable distribution of tax proceeds from the production and the consumption of
internationally traded goods, taking into account the jurisdictions involved and taxpayers
of each jurisdiction.

 More recently, equity has informed the drive to eliminate international tax avoidance:
taxpayers should act fairly in relation to the fiscal authorities where they reside, operate
or invest.

Capital export neutrality (CEN)

 CEN determines that a resident should have no incentive/disincentive to invest in or

outside its state of residence.

 CEN is realised when the amount of tax that residents must pay on their worldwide
income to their state of residence is the same whether they invest inside or outside the
state of residence. Thus, CEN does not deter residents from investing overseas or
investing in their state of residence due to tax considerations and it facilitates the
expansion of the resident state’s residents into foreign markets.

 CEN is more difficult to realise when the tax rates of the residence state are lower than
those in the host state.

 CEN can only be achieved when either a full credit is provided or an ordinary credit is
granted by a state that has a tax rate higher than the state of investment.

Capital import neutrality (CIN)

 CIN requires that investments within a country should be subject to the same level of
taxes regardless of whether they are made by a resident or a non-resident.

 States that wish to ensure that all investment within their economies are treated equally
for tax purposes generally exclude all foreign-source income from their tax base.

 CIN states exempt from taxation all residents’ foreign-source income and only tax the
domestic source income of residents and non-residents.

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Capital ownership neutrality (CON)

 CON requires that the ownership pattern of assets is efficient.

 CON is in evidence when tax rules do not influence who owns assets.

 CON is based on the view that the ownership of assets affects the productive use of
those assets and therefore ITP should not distort the decision as to who owns those
assets.

National neutrality (NN)

 NN focuses on the need for a sovereign state to maximise its own national interest.

 NN effectively creates a disincentive for its residents to invest overseas.

 States that wish to ensure that their residents maximise their investment domestically
frequently adopt the deduction method of relief from double taxation.

 NN critics argue that adopting states are focused on the advancement of their own
economies at the expense of non-residents, who are considering investing within their
borders.

Market neutrality (MN)

 MN provides that if two firms compete with each other in the same market, they should
face the same overall effective tax rates.

 By being subjected to the same effective tax rates, the theory is that competition between
the two firms is not distorted.

Conclusion

 In an ITP context, equity requires taxpayers to pay their fair share of tax revenue to the
states in which they have personal and economic connections.

 In the same context, efficiency concerns how best to constrain the economic activity of
taxpayers.

 Most influential to ITP have been CIN and CEN.

 Without tax rates and bases being the same across all jurisdictions, it is impossible for
CEN and CIN to be achieved simultaneously. Thus, CEN and CIN are incompatible.

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Question 4

This question gives students an opportunity to explain the nature of the profit split method and
to discuss its application in theory and/or practice. Given that the OECD issued draft guidance
in June 2017, as part of the BEPs project, it is a topical subject with material readily available
for discussion. Furthermore, students might be interested in discussing the conceptual ‘divide’
between the profit split method and global formulary apportionment or the adoption of some
type of economic theory, such as Game Theory, to underpin the profit split method.

The following is one possible schematic.

Introduction

The profit split method (the “PSM”) is a transfer pricing method that allocates the combined
operating profit or loss from a transaction to associated enterprises in a manner that reflects
the division of profits that would have been expected in an arm’s length arrangement. This may
include a division based on the relative contribution of each participant to the controlled
transaction (the “transaction”). The relative value of each participant’s contribution will normally
be determined by taking into account the functions performed, risks assumed, and resources
employed by the participant. There is a variety of profit split methods, including the comparable
profit split method, the residual profit split method, and the total profit split method (IBFD, 2017).

Most Appropriate Method

As part of BEPS, Action 10, the OECD released revised draft guidance on PSM in June 2017.
Although the OECD Guidance is non-exhaustive (and other indicators might apply), it identifies
three indicators where the PSM may be most appropriate when analysing a transaction.

1. Unique and valuable contributions by each of the parties to the transactions.

Contributions (e.g. functions performed or assets used/contributed) are unique and
valuable where: they are not comparable to contributions made by uncontrolled parties
in comparable circumstances; and their use in business operations is a key source of
actual/potential economic benefit.

2. A high degree of integration in certain business operations. This means that the way in
which one party ‘performs functions, uses assets and assumes risks’ (FARs) is
interlinked with – and cannot reliably be evaluated in isolation from – the way in which
another party FARs. Integration may also imply interdependency.

3. Shared assumption of significant risks or separate assumption of closely-related risks.

This describes two situations where the playing out of the risks of each party cannot be
reliably isolated.

Bilaney (2017) holds that indicator three is not a separate indicator. Rather, the extent of its
presence is a relevant factor in concluding whether the PSM is an appropriate method in respect
of a transaction that exhibits one or both of the first two indicators.

Group Synergies

Bilaney (2017) suggests that synergies alone cannot be an indicator to support the application
of PSM. However, it is possible that group synergies exist where there is a high degree of
integration” or where “unique and valuable contributions” are made. Where, due to such group
synergies an incremental profit has arisen, it should be included in the combined profits to be
allocated under the PSM.

Actual vs Anticipated Profit Split

The 2017 Draft Guidance recognizes the following two PSM approaches:

 the profit split of actual profits (PS Actual), particularly under Indicator Three; and

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 the profit split of anticipated profits (PS Anticipated), particularly where one party does
not share the same level of risk, which would become clear after entering into the
transaction.

Bilaney (2017) considers:

“it is likely that two independent parties transacting on the basis of splitting the
anticipated profits would review the outcomes periodically to assess the
commercial viability of continuing to transact on the basis of splitting anticipated
profits. In any independent-party scenario, the parties would most likely seek to
renegotiate, or exit from, the arrangement if the outcome varied significantly from
the anticipated one, as anticipated profits are based on estimates and forecasts.
As a point for refinement of the guidelines on the transactional profit split method,
it would be appropriate if the two approaches to profit splitting suggested in the
2017 Draft Guidance were modified by the OECD so as to be presented as two
different stages of a single approach”.

Game Theory

The Guidance provides for various profit splitting factors, e.g. asset- and cost-based. Bilaney
(2017) suggests the use of game theory in relation to profit splitting factors. Game theory is an
empirical economic theory that is used to analyse bargaining situations and outcomes. It is
suitable for use in analysing arm’s length results in potential bargaining situations. In the
absence of a larger market, bargaining is central. Game theory could lead to results that are in
line with other appropriate methods.

Conclusion

There is clearly a move by the OECD towards making PSM more practical in its application.
What we have seen above are a number of suggestions from Bilaney (2017) that might help
the OECD achieve that goal, as well as exploring the definition and appropriateness of PSM is
a variety of contexts.

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Question 5

This question gives students the opportunity to define international tax law. Inherent in such a
definition is the question whether international tax law is indeed a form of international law.
Commentators are divided on this matter and students have the opportunity of discussing this
divergency. Students may also wish to consider whether international tax law is a form of
international public or private law. Once again, for those commentators who hold that
international tax law is a form of international law, there is a significant divergency in this area..

The following is one possible schematic.

Introduction

 Traditionally, international tax law (ITL) refers to treaty provisions relieving international
double taxation.

 More broadly, ITL includes domestic legislation covering foreign income of residents
(worldwide income) and domestic income of non-residents; domestic legislation and
treaty provisions containing rules against international tax avoidance and evasion;
domestic legislation and treaty provisions relieving international economic double
taxation; EU Directives and domestic legislation concerning cross-border direct taxation;
and international rules and domestic legislation on the taxation of diplomats, consular
officers and officials of intergovernmental organisations (IBFD, 2017).

International Tax as International Law

 Some commentators view ITL as a subset of the broader notion of international law. This
view is justified by the network of DTAs that states enter into and the view that initiatives
that are complied with by many states are a form of soft or customary law.

 According to Avi-Yonah, ITL constitutes a regime, which itself forms part of international
law. So, countries are constrained by the international tax rules they adopt.

 Supporters of the international tax regime view cite the massive network of bilateral DTAs
that contain definable principles that underlie the treaties and are common to many of
them. They also reference the growing co-operation and co-ordination of tax policies and
rules across countries with disparate tax systems.

International Tax Law as Public International Law

 Public international law (PIL) governs the relations between states, determining their
mutual rights and obligations.

 PIL consists of those principles/rules of conduct that states feel bound to, and do,
observe.

 In some cases, PIL can also bind persons.

 PIL consists of:

- Customary international law consists of international state practice or the

commonly-held view of states on certain matters plus a belief that there is an
attendant obligation. It is necessarily ambiguous and quite hard to ‘pin down’,
especially in relation to the commencement of a particular ‘rule’. Some customary
international law has been codified in treaties.

- General principles of law are the international aspects of domestic laws.

 Some authors think that ITL consists of those principles of PIL which involve jurisdictional
conflict in relation to cross-border transactions. This view stems from the fact that tax

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laws tend not to be ‘international’ and ITL therefore consists of the international aspects
of domestic tax law plus customary practices plus tax treaties.

 Tax treaties and European Union tax laws are both overriding and enforceable
international laws of taxation. So, ITL is much more than just a subset of PIL.

International Tax Law as Domestic Law

 Some commentators view ITL to be a misnomer as rules relating to cross-border

transactions form part of each state’s domestic tax regime.

 Related to this point is the fact that several commentators, including Graetz and
Rosenbloom, do not consider that the rules and principles that have emerged over the
years together constitute a separate international tax regime. Their view is that states
are free to legislate as they see fit.

 So, any co-operative measure is not a constraint on a state’s right to claim the right to
tax but rather an extension of their sovereign right to manage their fiscal affairs in the
most beneficial manner.

Conclusion

 ITL describes the rules and principles that together determine the tax consequences for
individuals and businesses that enter into cross-border transactions.

 Despite this overarching theme, there is no consensus on the precise nature of ITL.

 There are divergent views concerning whether:

- international tax constitutes a form of international law; or

- the rules and principles that many states apply when drafting their domestic rules
and negotiating their many double taxation agreements merely form part of each
state’s domestic tax regime.

 This divergence goes to the heart of the extent of a state’s jurisdiction to tax.

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PART B

Question 6

This question concerns the cross-border exchange of information between revenue authorities.
It raises some interesting issues and, at the very least, provides students with an opportunity
to discuss OECD MTC, Article 26 (and Commentary); and the interpretation of tax treaties.
Some students may wish to distinguish between (i) the procedural aspects of the
communications between the two competent authorities requesting the exchange of information
and (ii) the information relating to the object of the request, which is the main focus of Article
26 and the Commentary.

The following is one possible schematic:

Introduction

Article 26 of the OECD MTC, and thus the K/B DTA, concerns exchange of information between
competent authorities (CAs). Paragraph 2 provides that:

“[a]ny information received ... by a Contracting State shall be treated as secret ...
and shall be disclosed only to persons or authorities ... concerned with the
assessment or collection of, the enforcement or prosecution in respect of, the
determination of appeals in relation to the taxes referred to”.

The core issues that flow from this are (i) whether C Ltd is precluded from discovering
documents pertaining to the communication between the two CAs because those documents
are secret, and (ii) whether judicial review proceedings are within the contemplation of Article
26 of the K/B DTA, given that Article 26(2) of that DTA does not include the phrase “or the
oversight of the above”.

Discoverable

Paragraph 12 of the Commentary to Article 26 provides that:

“the information may also be communicated to the taxpayer, his proxy or to the
witnesses. This also means that information can be disclosed to governmental or
judicial authorities charged with deciding whether such information should be
released to the taxpayer, his proxy or to the witnesses.”

This passage clearly envisages situations where a taxpayer and its agent are legally barred
from receiving the exchanged information.

Presuming that the power conferred on the Commissioner by the TAA is open to judicial scrutiny
by way of judicial review, one might assume that, ordinarily, a taxpayer served with a Notice
would be able to ask for the ground upon which it was issued and seek access to material kept
about them. While there are grounds upon which such requests could be refused, it is unlikely
they would include a blanket and undifferentiated claim of confidentiality. Each request would
need to be considered on its merits. However, the Commissioner’s position will be that such a
blanket and undifferentiated claim of confidentiality will be justifiable in the context of an
exchange of information per the secrecy requirement under Article 26(2).

The fact that information comes into a Commissioner’s hands pursuant to a DTA process
arguably does not negate the need for the application of normal domestic law safeguards.
Interestingly, given the statement in the Commentary to Article 26, para. 11, these safeguards
only need be relied upon if Kalgool refuses to consent to the disclosure. Paragraph 11 of the
Commentary to Article 26 provides that:

“If necessary, the competent authorities may enter into specific arrangements or
memoranda of understanding regarding the confidentiality of the information
exchanged under this Article.”

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Thus, international comity comes first, which makes sense given the international relations
dimension of DTAs.

Assuming Kalgool requires confidentiality, the court would then need to consider whether the
public interest in disclosure of the information is outweighed by the public interest in withholding
it. The need for that balancing exercise suggests that it would be prudent for reasons to be
given by Kalgool for any refusal.

Judicial Review

Article 26 of the K/B DTA should probably be read as if it contained the additional final words
of Article 26 of the OECD MTC ‘or oversight of the above’. Such an approach resolves any
ambiguity in the interpretation of Article 26. It is consistent with the common approach of courts
to taxpayer secrecy and discovery in judicial review and is supported by the Commentary:

12.1 Information can also be disclosed to oversight bodies. Such oversight bodies
include authorities that supervise tax administration and enforcement authorities
as part of the general administration of the Government of a Contracting State.
In their bilateral negotiations, however, Contracting States may depart from this
principle and agree to exclude the disclosure of information to such supervisory
bodies.

“Oversight” includes exercise by the courts of their supervisory jurisdiction over all executive
action and over the exercise of statutory powers of decisions related to those functions: Thiel v
FCT (1990) 171 CLR 338.

If there have been any changes to the Commentary since 1982, given that there has been no
relevant substantive change to the main provision as per the OECD MTC, those changes are
probably best viewed not as recording an agreement about a new meaning but as reflecting a
common view as to what the meaning was and always had been.

Conclusion

The K/B DTA documents are probably not to be disclosed. It is not for C Ltd to ask a Bostrap
court to question in review proceedings whether information sought by the KRA is necessary
for carrying out DTA provisions, or for Kalgool’s domestic law, or is available under the laws of
or in the normal course of administration in Kalgool. Any weighing of the claim for confidentiality
against the fair and proper conduct of the judicial review proceedings probably has to come
down in favour of confidentiality. International comity would be compromised if courts liberally
made pronouncements questioning the underlying bona fides of requests made by foreign tax
authorities. That would be to usurp the role of the executive.

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Question 7

This question tests the ability of students to understand the tax implications of different forms
of direct investment overseas. It requires students to understand the difference between trading
with and trading in a foreign jurisdiction. The client, Cipher plc, is clearly looking for a tax
strategy that has the least impact on group profits. Thus, students will need to frame their
answers with that in mind.

This question also tests whether students are aware of what the tax implications are when firms
send their employees abroad to look after their foreign customers. This question requires
students to be aware of the tax implications not only for Cipher plc, but also for their employees.
Extra credit will be provided to those students who identify any relevant material in “The Base
Erosion and Profit Shifting Public Discussion Draft: BEPS Action 7: Additional Guidance on
Attribution of Profits to Permanent Establishments: 22 June-15 September 2017”.

The following is one possible schematic.

Part 1

Sales through independent agents in Belagio

If Cipher trades through an independent agent, no PE is created and none of Cipher plc’s profits
are taxable in Belagio: Arts.7(1)&5(6). However, care should be taken to ensure the agent is
independent both legally and economically. This is a question of fact, the principal criteria being:

 the number of other parties represented by the agent;

 the amount of time spent on Cipher plc’s business; and

 whether the agent bears the economic risks and rewards of working on behalf of Cipher
plc (Commentary Art.5(6), para.38)

Care should also be taken to ensure the agent is acting in the ordinary course of its business
in relation to the sale carried out on behalf of Cipher plc. This calls for an examination of the
other businesses being represented by the agent. For example, if all the agent’s other
customers were ‘non-tech sector’, the agent would not be acting in the ordinary course of its
business representing a manufacturer of cryptographic hardware/software.

As long as the agent is genuinely independent in relation to the above, Cipher plc would not be
taxable on sales made through the agent in Belagio and could deduct the sales commission
from its profits in Ardleterre. Where the agent fails the independence test, the agent would be
regarded as dependent in relation to the sales for Cipher plc. Cipher plc would thus have a
dependent agent PE in Belagio and be taxable there in the same way as if it had set up its own
sales team.

Export to Belagio, selling through local sales team and warehouse

The warehouse will not in itself constitute a PE, thus creating a taxable presence in Belagio. It
is “a store of goods” specifically exempted under the examples of preparatory or auxiliary
activities under Art.5(4). However, the sales team would have premises and be contracting in
the name of Cipher plc as economically dependent agents. This would constitute a PE under
both Arts.5(1)&(5).

The profits on sales in Belagio will be taxable there, hypothesising the sales team as a distinct
and separate entity. This would produce lower taxable profits in Belagio than if both
manufacture and sales were conducted there.

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 Paper 1 (December 2017)

Own factory and sales team in Belagio

Cipher plc would have a PE under both Arts.5(1)&(5). The factory would constitute a fixed place
of business of Cipher plc in Belagio (Art.5(1)) and the sales team would constitute dependent
agents (Art.5(5)). Neither manufacture nor sales are preparatory or auxiliary activities under
Art.5(4). The profits generated by the factory and sales team would thus be taxable in Belagio
under, for example, the ‘Authorised OECD Approach’, by hypothesing the factory and sales
team as a distinct and separate entity.

This model of operation is therefore not a great strategy from a tax perspective. There is no
scope for a licence fee between the head office in Ardleterre and branch in Belagio, as they are
legally a single entity. Therefore, there is no opportunity to mitigate the tax payable in Belagio
to take account of the intellectual property already generated by Cipher plc prior to establishing
its business in Belagio.

Establish a subsidiary and manufacture under licence

Under Art.7, Cipher plc is not taxable on its business profits in Belagio unless it has a PE there.
A subsidiary would constitute a separate legal entity: Art.5(7). Thus, the subsidiary would be
taxable on its profits only in Belagio; and Cipher plc would remain taxable only in Ardleterre.

Care is required to ensure the subsidiary does not become a PE of Cipher plc. A subsidiary
could constitute a fixed place of business for Cipher under Art.5(1). If the subsidiary regularly
makes premises available for Cipher plc’s visiting staff, it could constitute a fixed place of
business of Cipher plc even though no formal legal right exists on the part of Cipher plc (Art.5
Commentary, para.4.1).

Care is also required to prevent the subsidiary constituting a dependent agent of Cipher plc
under Art.5(5). A dependent agent can be a company (Art.5 Commentary, para.32). This is
unlikely though as presumably the subsidiary will not sell Cipher plc’s hardware or software, as
it will be selling its own, which it manufactures/sells under licence. Sales by the subsidiary of
its own products manufactured/sold under licence would not be sales on behalf of Cipher plc
because of the legal separation of parent and subsidiary recognised by Art.5(7). But if ever the
subsidiary acted as a sales outlet for hardware produced by Cipher plc in Ardleterre, this would
make the subsidiary an agency PE of Cipher plc; merely soliciting and receiving orders without
finalising them would be sufficient (Art.5(5) Commentary, para 32.1).

Belagio will recognise the licence fees paid by the subsidiary as constituting an arm’s length
price if the subsidiary can demonstrate that it had undertaken a transfer pricing study and
complied with documentation formalities in Belagio. If not, Belagio is likely to seek to adjust the
price downwards under Art.9, read alongside the OECD Transfer Pricing Guidelines 1996 (as
amended) by focusing on functions performed, assets used and risks assumed by the
subsidiary in Belagio. The result would be an increased taxable profit for the Belagio subsidiary
at the higher rates prevailing there. Consideration should be given to reaching an advance
pricing agreement or other form of informal clearance with the Belagio tax authority.

Subject to there not being a PE and Belagio recognising the licence fee as a correct arm’s
length price, the contract manufacturing and licence operation would be a good tax strategy.
The licence fees would reduce profits of the subsidiary and render the fees taxable at the lower
rate in Ardleterre.

Part 2

Tax consequences for Cipher plc

Despite the fact they are staying in hotels, the fact that the technical experts are working onsite
for their customers renders the answer reasonably straightforward. They have a fixed place of
business (Art.5(1)) and their activities are seemingly neither preparatory nor auxiliary to the
principal profit earning activity of Cipher plc – the sale of hardware and software (Art.5(4)). The
technical experts would therefore create a taxable presence for Cipher plc in Belagio.

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A possible exception would be to regard the business of Cipher plc as the manufacture and
sale of hardware, with the software element being treated as an incidental aspect of the
hardware sales. The Commentary on Art.5 provides for the possibility of a ‘service PE’
(para.42.39 et seq).

Tax consequences for the technical experts

In principle, the technical experts’ wages are taxable in Belagio under the provisions of Art.15(1)
because they carry out work there. However, so long as the engineers do not remain in Belagio
for more than 183 days within any 12-month period and their remuneration is paid by Cipher
plc, which is resident in Ardleterre, they would fall within the exception in Article 15(2)(a)-(c) so
that they are taxable solely in Ardleterre.

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