Published on October 29, 2007
The Model Treaties: The Model Treaties History and Development United States vs. Europe: United States vs. Europe The U.S. began considering the need for tax treaties in the early 1920s. Before then, there was no international standard for relieving double taxation. The U.S. was alone in providing a unilateral foreign tax credit. By relieving U.S. residual taxation, the FTC cedes “residence-based” taxation to “source-based” taxation. The FTC was therefore seen as a gift of revenue to other countries. In stark contrast, Britain imposed worldwide taxation and provided a FTC that was extremely limited and generally preserved its residence-based taxation. Other European nations, especially France and Italy, relied heavily on source-based taxation and therefore vigorously defended the U.S. position of ceding residence-based taxation to that of source. International Chamber of Commerce: International Chamber of Commerce Formed in 1919 by 15 nations, to facilitate discussion surrounding promotion of international trade and investment. The most influential nations were Belgium, France, Italy, the United Kingdom and the United States. In 1921, the ICC adopted a resolution that tax jurisdiction turned on the nature of the tax. Under direction from the U.K., distinctions were made between “super” (progressive) and “normal” (flat rate) taxes; jurisdiction over the former was to be based on citizenship, the latter on source The U.S. rejected this resolution and endorsed closer adherence to the U.S. system (ceding residence in favor of source-based tax jurisdiction) The ICC synthesized the U.K and U.S. views in a set of resolutions, done in Rome, in 1923 (the “Rome Resolutions”). The Rome Resolutions: The Rome Resolutions The Rome Resolutions incorporated the concept of a classification and assignment system for different categories of income e.g. income from real estate to the nation where located, and income from business divided among source nations according to relative contributions It also crystallized the notion of “residence” versus “source,” rejecting the notion of citizenship that had been promoted by the U.K. Finally, it proposed the allocation of business profits between source nations by some objective mechanism. The Rome Resolutions essentially solidified the terminology that formed the foundation of modern tax treaties. Reaction to the Rome Resolutions: Reaction to the Rome Resolutions The U.S. opposed the allocation of all types of income to one jurisdiction over another, preferring adherence to its own model of protecting source-based over residence-based taxation in all cases, but otherwise approved of the Rome Resolutions. The U.K. entirely opposed the Rome Resolutions, especially the emphasis on source-based taxation: they argued that all taxation should be residence-based, like the British system. The U.K. demonstrated its unyielding commitment to residence-based taxation in a 1926 treaty with the new Irish Free State, which exempted non-residents from taxation. The U.K. did not complete any other new treaties until it signed one with the U.S. in 1945—it took almost 20 years for the U.K. to compromise its preference for residence-based taxation. Why did the US favor source, the UK residence?: Why did the US favor source, the UK residence? The U.K. was a net exporter of capital. The U.S. was also a net exporter of capital at that time. However, T.S. Adams as tax advisor to the Treasury Dept, writer of the FTC, and chief international tax negotiator on behalf of the U.S., preferred source based taxation for several reasons. he wanted to avoid antagonizing debtor nations (esp France and Italy), who comprised the bulk of ICC members; the international balance of payments was overwhelmingly in the U.S.’s favor, permitting generosity in source rules to capital importers; and he had already instituted a preference for source-based taxation domestically, by getting the FTC enacted. 1923 Compromise: 1923 Compromise The Rome Resolutions thus failed to resolve anything except drawing the battle lines clearly. In 1923, the ICC endorsed the principle that in the long run, all taxation should be residence-based, but in the short run, nations should work toward developing bilateral treaties implementing the American-style FTC. Nevertheless, the impasse continued. Enter the League of Nations: Enter the League of Nations The League of Nations was conceived during the first World War, and established in 1919 under the Treaty of Versailles “to promote international cooperation and to achieve peace and security.” League of Nations Member Countries, 1919: League of Nations Member Countries, 1919 League of Nations Member Countries: League of Nations Member Countries League of Nations Focus on Tax Treaties: League of Nations Focus on Tax Treaties In 1920, the League of Nations held an international financial conference in Brussels. They determined that double taxation was a serious impediment to international relations and world production. The financial committee of that conference referred the question of double taxation to four economists: M. Bruins, M. Einaudi, M. Seligman, and Josiah Stamp, who began working on a report. In 1922, the financial committee decided that both double taxation and tax evasion should be studied together, so they put together a new group of six people who were high officials in their home country’s fiscal administration, to discuss the problem of double taxation. 1923 Report of the 4 Economists: 1923 Report of the 4 Economists In 1923, the four economists released their report. It had little impact on the ICC. The 1925 Report: The 1925 Report Meanwhile, the Committee of Technical Experts had been formed. it included six experts from LoN member coutnries. The 6 technical experts agreed upon a series of resolutions which they submitted to the LoN’s financial committee in 1925 (the 1925 Report). This report distinguished taxes on global income—now called “personal taxes”—and all other taxes—now called “impersonal taxes.” Under this theory: Jurisdiction over personal taxes was to be based on residence, and Jurisdiction over impersonal taxes was to be based on source. This was an attempt to allow both creditor nations (U.K., Netherlands, U.S.) as well as debtor nations (France, Italy) specific jurisdiction over different types of taxes. The Technical experts said that the distinction was made “purely for practical reasons.” The 1925 Report: The 1925 Report The 1925 report was more favorable to source-based taxation than the 1923 report. In the 1925 report, the experts also suggested expansion of the committee in order to start working on a model convention. Technical Experts: Technical Experts The newly expanded committee of technical experts comprised 14 members. 13 were from LoN member countries; the 14th was a representative from the United States (T.S. Adams). The ICC was invited to send a delegation to the three meetings held by the committee of experts in 1926 and 1927. The new committee began by reviewing the 1925 report. They focused on drawing up a standard convention, but determined that a multilateral or “collective” convention would be impossible because of vast differences in tax systems. Therefore the Committee drafted what they called “standard bilateral conventions,” which, if used by governments, would collectively introduce a measure of uniformity in international fiscal law. Such uniformity might lead, they thought, to a system of general conventions that would make possible the unification and codification of the rules previously laid down. The First Model Tax Treaty: The First Model Tax Treaty The model convention reflected the 1925 report, providing that personal taxation would be taxed on the basis of residence and impersonal taxation would be taxed on the basis of source. Implementation: Implementation The binary scheme of personal vs impersonal worked well with nations like France, which had two distinct income taxes that fit into these categories. However, it did not work well in the context of U.S. or U.K. tax structures. For example, the U.S. imposed both a flat normal tax and a graduated surtax on individuals, plus a flat normal tax on corporations. Which were the impersonal taxes? The U.S. therefore argued against the personal/impersonal distinction as being too vague for implementation. It advocated instead the use of “origin taxes” and “residence taxes,” a tautological distinction that essentially illustrated a desire to write the U.S. international tax system into a model treaty. Model Treaty-Second Draft: Model Treaty-Second Draft The Committee of Experts thus drafted two model treaties, the second reflecting a combination of the U.S. and U.K. positions. This draft made no mention of personal/impersonal: instead, it articulated a general preference for residence-based taxation (the U.K. position). However, it also permitted source-based taxation, most notably on business income, and called for nations to grant U.S.-style tax credits. League of Nations—Subsequent Drafts: League of Nations—Subsequent Drafts The “Mexico Model,” adopted in 1943 reflected the interests of capital-importing nations by providing for extensive source-based taxation of most classes of income The “London Model,” adopted in 1946 reflected the interests of capital-exporting nations by emphasizing residence-based taxation. The League of Nations dissolved in 1946 (it was succeeded by the United Nations). Enter the OECD: Enter the OECD The League of Nations Model continued to be the blueprint for tax treaties from the 30s to the 60s, with some treaties reflecting the concepts embodied in the Mexico and London Models. Meanwhile, the Organisation for European Economic Co-operation was developed in 1948, to coordinate the Marshall Plan. The OEEC transformed in 1961 into the Organisation for Economic Co-operation and Development, a group of 30 developed countries including the U.S. OECD Member Countries: OECD Member Countries The OECD Model: The OECD Model The OECD soon began to look at the matter of tax treaties, and first issued its own Model in 1963. As a product of the major industrialized nations that comprise its membership, the OECD’s model emphasizes the views of capital-exporting countries. Primary taxing jurisdiction is given to the residence state; and therefore Elimination of double taxation is primarily achieved by way of source-state exemption (with FTC as a backstop). The OECD recommended that its member nations should “conform to the Draft Convention…as interpreted by the commentaries,” when concluding or revising their bilateral treaties. The OECD Model, Cont.: The OECD Model, Cont. The OECD updated its model treaty in 1977 and again in 1992. Since then, it updates every few years (1995, 1997, 2000, and 2003). Each update reflected the experience of member countries in negotiating tax treaties, and changes in the domestic tax systems of the member states. The OECD Model quickly became the standard for member as well as non-member states. The U.S. never adopted any of the OECD Model Treaties as its primary negotiating document. However, these models significantly influenced all U.S. treaties entered into after 1963. Writers of 1st Model vs Writers of 2d Model: Writers of 1st Model vs Writers of 2d Model Enter the UN: Enter the UN Its predecessor organization, the League of Nations, had been responsible for the first model treaties. However, the UN did not pick up on this activity until 1968, when it was determined that the OECD Models were not appropriate for use by developing countries, which are primarily capital-importing (and therefore reliant on source-based taxation). In 1968 the UN formed the “Ad Hoc Group of Experts on Tax Treaties Between Developed and Developing Countries” to formulate guidelines. It took them 12 years to come up with the UN Model Treaty. The UN Model of 1980 structurally resembled the OECD Model of 1977. However, the UN Model emphasized the primacy of source-based taxation. Members of UN Group of Experts, 1968: Members of UN Group of Experts, 1968 OECD Model vs UN Model: OECD Model vs UN Model UN Model Development: UN Model Development The original UN Model was updated and released in 1999 as a draft and 2001 as a new Model. Meanwhile, in the U.S. … : Meanwhile, in the U.S. … Since its first treaty with France (1935), U.S. tax treaty negotiations were based on a model developed by Treasury. The model was intended for U.S. negotiators and was not officially released. After WWII, a model based on the 1945 U.S.-U.K. treaty became the unofficial model. Again, it was intended for U.S. negotiators and was not released. After the publication of the 1963 OECD Model, the then unofficial US Model met with more resistance in negotiations. In the 1970s, the U.S. finally determined that adoption of treaty concepts accepted by most other countries would be the only way for the U.S. to expand and modernize its existing tax treaty network. Development of the US Model: Development of the US Model In 1976, Treasury published the first official U.S. model treaty. This Model followed the 1963 OECD Model both in structure and terminology. In 1981, Treasury released another draft. The main change was the addition of Art. 16, a limitation on benefits (LOB) clause designed to prevent treaty shopping. The 1981 Model was withdrawn in July, 1992. Another model was not released until 1996. The 1996 Model clarified terminology, reflected changes in U.S. internal tax provisions, and tightened the LOB clause. A new model was released in November of 2006.).