Project Report

TAXATION LAW IN INTERNATIONAL ARENA

TOPIC- United States Model Income Tax Convention 2016

SUBMITTED TO: SUBMITTED BY:

Dr. Juliee Sharma JUBIN DAS

AMITY LAW SCHOOL, NOIDA A3268723006

AMITY LAW SCHOOL,

NOIDA
 ABSTRACT

Many of the revised provisions reflect current negotiating positions developed in actual tax treaty
negotiation sessions, and on the whole, the 2016 Model Treaty should be seen as a natural
progression, as taxpayers and treaty partner countries have also adapted to existing treaties

The 2016 Model denies treaty benefits for related party-interest payments, royalty payments, or
guarantee fees within the scope of Article 21 if the beneficial owner of the payment benefits
from a special tax regime with respect to the payment. The term “special tax regime” is defined
as any legislation, regulation or administrative practice that provides a preferential effective rate
of taxation on an item of income or profit.

This study focuses on one of the new provisions of the 2016 U.S. Model, i.e. the special tax
regimes clause provided for in Article 3 (1) (l), which impinges on several Articles of the Model.
The main purpose of this provision is to deny certain treaty benefits at the source when the
person claiming the benefits enjoys a preferential tax regime in the resident state. The referred
contribution analyses the legal framework of the provision taking into account the Base Erosion
and Profit Shifting project and the US tax treaty policy. In this regard, the special tax regimes
clause deviates from the approach taken by most states in respect of to how to avoid the
application of tax treaty benefits to preferential tax regimes. Until now, tax treaties have usually
listed the regimes which were excluded whilst disregarding the possibility of establishing a
general wording concerning the meaning of preferential tax regimes. This research paper
concludes by evaluating the New Model in light of the emerging trend to use tax treaties not just
to prevent double taxation, but also to combat double non-taxation.
 INTRODUCTION

The major purpose of an income tax treaty is to mitigate international double taxation through
tax reduction or exemptions on certain types of income derived by residents of one treaty country
from sources within the other treaty country. Because tax treaties often substantially modify U.S.
and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the
income tax consequences of any outbound or inbound transaction. The U.S. currently has income
tax treaties with approximately 58 countries. This article discusses the implications of the United
States- India Income Tax Treaty. There are several basic treaty provisions, such as permanent
establishment provisions and reduced withholding tax rates, that are common to most of the
income tax treaties to which the United States is a party. In many cases, these provisions are
patterned after or similar to the United States Model Income Tax Convention, which reflects the
traditional baseline negotiating position. However, each tax treaty is separately negotiated and
therefore unique. As a consequence, to determine the impact of treaty provisions in any specific
situation, the applicable treaty at issue must be analyzed. The United States- India Income Tax
Treaty is no different.

The treaty has its own unique definitions. We will now review the key provisions of the United
States-India Income Tax Treaty and the implications to individuals attempting to make use of the
treaty.Definition of ResidentThe tax exemptions and reductions that treaties provide are available
only to a resident of one of the treaty countries. Income derived by a partnership or other pass-
through entity is treated as derived by a resident of a treaty country to the extent that, under the
domestic laws of that country, the income is treated as taxable to a person that qualifies as a
resident of that treaty country. Under Article 4 of the United States- India Income Tax Treaty, a
resident is any person who, under a country’s internal laws, is subject to taxation by reason of
domicile, residence, citizenship, place of management, place of incorporation, or other criterion
of a similar nature. Because each country has its own unique definition of residency, a person
may qualify as a resident in more than one country. Whether a person is a resident of the United
States of India for treaty purposes is determined by reference to the internal laws of each
country.1

1
Anthony Diosdi Unraveling The United States- India Income Tax Treaty, 2021
 After a decade, the Treasury Department issued a new U.S. Model Income Tax Convention,
which is the baseline text the Treasury Department uses when it negotiates tax treaties. The 2016
Model includes a number of new provisions intended to more effectively implement the Treasury
Department’s longstanding policy that tax treaties should eliminate double taxation without
creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance. 2

Preferential Tax Regimes: The 2016 Model does not allow a reduction of withholding taxes on
payments of highly mobile income—income that taxpayers can easily shift around the globe
through deductible payments such as royalties and interest—that are made to related persons that
enjoy low or no taxation with respect to that income under a preferential tax regime. To protect
against treaty abuse, the 2016 Model contains rules that deny treaty benefits on deductible
payments of highly mobile income that are made to related persons that enjoy low or no taxation
with respect to that income under a preferential tax regime. 3

Article 11 (Interest) includes a new rule that would allow a treaty partner to tax interest arising
in that country in accordance with domestic law if the interest is beneficially owned by a related
person that benefits from “notional interest deductions”.

New Article 28 (Subsequent Changes in Law) obligates the treaty partners to consult with a
view to amending the treaty as necessary when changes in the domestic law of a treaty partner
draw into question the treaty’s original balance of negotiated benefits and the need for the treaty
to reduce double taxation.

Corporate Inversions: The 2016 Model also includes measures to reduce the tax benefits of
corporate inversions. Specifically, it denies reduced withholding taxes on U.S. source payments
made by companies that engage in inversions to related foreign persons.

Required Arbitration: The 2016 Model contains rules requiring that such disputes be resolved
through mandatory binding arbitration. The “last best offer” approach to arbitration in the 2016
Model is substantively the same as the arbitration provision in four U.S. tax treaties in force and
three U.S. tax treaties that are awaiting the advice and consent of the Senate.

2
Julie Martin, 2016 US model tax treaty differs significantly from draft version, MNE TAX, 2016
3
Kim Brooks, International Tax: Tax Treaties, (Halifax, Nova Scotia, 2020)
Article 22 (Limitation on Benefits) has been updated to prevent so-called “treaty shopping” by
third-country residents that are not intended beneficiaries of the treaty. The 2016 Model includes
two new tests – a “derivative benefits” test and a “headquarters company” test. In addition, a
number of the preexisting LOB tests have been tightened to prevent abuse by third-country
residents.

Triangular PEs: The 2016 Model also includes a rule (located in new paragraph 8 of Article 1
(General Scope)) that is a revised version of the “triangular permanent establishment” rule that
has been included in some of the United States’ income treaties since the 1990s. The new version
of the rule addresses income treated by a residence country as attributable to a permanent
establishment and subject to little or no tax, as well as income that is excluded from the tax base
of the residence country and attributable to a permanent establishment located in a third country
that does not have a tax treaty with the source country. 4

US influence on BEPS proposals

In several respects previous US models have informed on the outcome of the treaty related work
product of BEPS. The proposed OECD limitation on benefits article is derived almost entirely on
the US approach. This reliance on US policy has flowed through to the OECD BEPS Action 6
(Treaty Abuse) final report which acknowledged that the US 2016 Model was not finalised, and,
that the OECD proposals on a draft LOB should be regarded as potentially open to revision in
light of US developments.

Other traditional features of US treaty policy, such as reserving the right to tax its own citizens as
if the treaty had not taken effect, and ignoring the place of effective management to resolve dual
residence of persons other than individuals, have found their way into BEPS proposals. 5

Permanent establishments

The divergence between the US and the OECD in treaty policy is the widest in relation to
permanent establishment and business profits. In updating its Model, the US has declined to

4
Ross Mcdonald, "Time Present and Time Past": U.S. Anti-Treaty Shopping History, Policy and Rules,American
Bar Association, 2016
5
Vega Borrego, The Special Tax Regimes Clause in the 2016 U.S. Model Income Tax Convention. Intertax. 2017
follow the “Authorised OECD Approach” to the attribution of profits reflected in the OECD
2010 Model. Despite the title, the AOA is controversial among OECD member countries and
even the UK has had mixed success in getting the new OECD Article 7 into its recent treaties.

Most noteworthy is that the new US Model does not give effect to BEPS Action 7. The
traditional permanent establishment definition is maintained by the US. The only minor
exception is a rule to address when the twelve-month period for construction or installation
permanent establishment is exceeded. This failure to extend taxing rights to commissionaire
relationships or to persons who merely negotiate as opposed to conclude contracts is likely to
cause difficulties when renegotiating treaties with those states that are keen to reverse the effect
of European successive supreme court decisions that commissionaires are not agency permanent
establishments under the existing wording of art 5(5) of the existing OECD Model. In its last
discussion draft on the meaning of permanent establishment, the OECD accepted that it was not
possible to reach a common view on the situations dealt with in those court decisions. In the
same vein, the restrictions on independent agency in the case of connected persons in art 5(6)
proposed in the BEPS Action 7 final report are not accepted in the US Model.

Similarly, the changes to the exceptions to permanent establishment for preparatory or auxiliary
activities are not adopted in the US Model. Again the BEPS Action 7 final report hints at a lack
of consensus on this issue, by offering the traditional version of art 5(4) as an alternative.

Rejection of the anti-fragmentation rule for activities of closely related parties that are
individually preparatory or auxiliary but collectively may not be, signals not only a divergence of
view on the necessity to address this issue, but also disapproval of regimes like the UK diverted
profits tax which seek to achieve the same result under domestic law in relation to “avoided
PEs”.

Hitherto, there has been a high degree of convergence in permanent establishment definitions in
tax treaties. This convergence has reduced the incentive for treaty shopping for permanent
establishment protection from source state taxation. Diversity of treatment increases that
incentive. 6

6
https://taxguru.in/income-tax/preamble-2016-model-income-tax-convention.html
Changes in domestic tax law

One of the strengths of international treaties as an instrument for regulating the allocation of
taxing rights between states is that treaties normally endure for a number of years, with the result
that states cannot change or increase the tax on international transactions and investment
unilaterally and with the frequency that domestic law changes are made. This brings a degree of
stability which fosters cross-border trade. Within this framework, the extent to which changes
can be made by domestic law, without breaching international obligations is typically limited to
changes in definitions permitted by art 3(2) of the OECD Model.

The 2016 US Model now addresses an entirely different kind of change, that is, the decrease in
tax or the introduction of tax incentives under domestic law that impact on international
transactions and investment. A new Article 28 deals with subsequent changes in law resulting in
a corporate tax rate less that 15 percent or 60 percent of the existing general statutory rate of
company tax. Such a change requires the treaty partners to consult with a view to amending the
treaty. The stated reason is that such changes may draw into question the treaty’s original
balance of negotiated benefits and the need for the treaty to reduce double taxation. Although
this signals when a renegotiation is needed, since parties are always able to terminate treaties on
notice, it exerts pressure on states to think about treaty consequences when seeking to make their
domestic tax laws more attractive.7

Harmful tax practices

In similar vein interest and royalties will be subject to domestic rates of tax if the recipients
benefit from a “special tax regime” where such items are taxed in the residence state at
preferential rates of less than 15 percent or 60 percent of the existing general statutory rate of
company tax on income from sales of goods or services. This appears aimed at intellectual
property box and finance box type regimes that are becoming increasingly common and the
subject of OECD BEPS Action 5 (Harmful tax practices).

7
US Model Treaty 2016: What does it say about the US and BEPS?https://kluwertaxblog.com/2016/02/21/us-
model-treaty-2016-what-does-it-say-about-the-us-and-beps/
During the last decades, bilateral tax treaties have shown a remarkable consistency with the
OECD Model. Although the BEPS Action plan called for a coordinated approach, the outcome
may well be greater diversity in tax treaties. Rather than taking the tax effects out of decision
making in international trade and investment, the tax effect may have a greater influence.

Limitation of Benefits New Provisions

(1) Active Trade or Business Test

Article 22 (Limitation on Benefits) has been updated and includes several tests that further
tighten when a tax resident may seek the benefits of a U.S. tax treaty to reduce withholding: (1)
an “active-trade-or-business test”, (2) a “derivative benefits” test and (3) a “headquarters
company” test. In addition, a number of the preexisting LOB tests have been tightened to prevent
abuse by third-country residents.

The first limitation test is on the ability of connected companies to aggregate their activities for
purposes of satisfying the LOB test that grants benefits with respect to income that is derived by
a company in connection with the active conduct of a trade or business in its country of residence
(the active-trade-or-business test). An active-trade-or-business test of the 2016 Model requires a
factual connection between an active trade or business in the residence country and the item of
income for which benefits are sought. Specifically, the 2016 Model requires that the treaty
benefitted income “emanates from, or is incidental to,” a trade or business that is actively
conducted by the resident in the residence state.8

An example that the Treasury Department stated that it may include in the forthcoming technical
explanation is dividends and interest paid by a commodity-supplying subsidiary that was
acquired by a company whose business in the residence state depends on a reliable source for the
commodity supplied by the subsidiary. Under this example, such dividends and interest would be
considered to emanate from the active trade or business of the parent. Another possible example
could involve dividends and interest paid by a subsidiary that distributes products that were
manufactured by the parent company in its state of residence. In contrast, the mere fact that two
companies are in similar lines of businesses would not be sufficient to establish that dividends or
interest paid
8
Julie Martin, 2016 US model tax treaty differs significantly from draft version, MNE TAX, 2016
Another possible example could involve dividends and interest paid by a subsidiary that
distributes products that were manufactured by the parent company in its state of residence. In
contrast, the mere fact that two companies are in similar lines of businesses would not be
sufficient to establish that dividends or interest paid between them are related to the active
conduct of a trade or business.9

(2) Derivative Benefits Test

The 2016 Model allows companies to qualify for treaty benefits under a “derivative benefits”
test, which is based on a broader concept of the longstanding “ownership-and-base erosion” test
(contained in paragraph 2(f) of Article 22 of the 2016 Model). While a form of derivative
benefits is included in most existing U.S. tax treaties with countries in the European Union, those
treaties limit third-country ownership to seven or fewer “equivalent beneficiaries,” which
generally must be resident in a member country of the European Union or North American Free
Trade Area trading blocs. In contrast, the derivative benefits rule in the 2016 Model contains no
such geographic restriction, instead requiring only that 95 percent of the tested company’s shares
be owned, directly or indirectly, by seven or fewer persons that are equivalent beneficiaries.

Under all derivative benefits provisions in existing U.S. tax treaties, in order to qualify as an
equivalent beneficiary with respect to income referred to in Article 10 (Dividends), 11 (Interest),
or 12 (Royalties), a third-country resident must be entitled, either under a comprehensive
convention for the avoidance of double taxation between its country of residence and the source
country or otherwise, to a rate of tax with respect to the particular category of income that is less
than or equal to the rate applicable under the tax treaty pursuant to which benefits are being
claimed. Companies that fail to satisfy this rate comparison test are not entitled to treaty benefits,
and therefore are generally subject to 30-percent gross basis withholding tax on U.S. source
payments of dividends, interest (other than interest of a portfolio nature), and royalties. The 2016
Model instead entitles a resident of the treaty partner to the highest rate of withholding to which
its third-country resident owners would be entitled. 10

9
Ross Mcdonald, "Time Present and Time Past": U.S. Anti-Treaty Shopping History, Policy and Rules,American
Bar Association, 2016
10
The 2016 Model Income Tax Treaty http://publications.ruchelaw.com/news/2016-12/Insights-2015-YiR-Model-
Treaties.pdf
(3) Headquarter Company Test

The 2016 Model requires a headquarters company to exercise primary management and control
functions (and not just supervision and administration) in its residence country with respect to
itself and its geographically diverse subsidiaries. The headquarters company rule in the 2016
Model also differs from existing headquarters company rules by including a base erosion test.
Furthermore, a headquarters company is only entitled to benefits with respect to dividends and
interest paid by members of its multinational corporate group; in the case of interest, this benefit
is limited to a 10-percent cap on withholding in the source state, which is consistent with the
general rate of withholding on interest that is permitted under the OECD’s Model Income Tax
Convention.

The new headquarters company test is analogous to the active-trade-or-business test in paragraph
3 of Article 22, which (as described above) generally entitles a company to treaty benefits
without regard to the residence of its owners when the company derives income from the source
state that emanates from, or is incidental to, such company’s trade or business in the residence
country.

Subsequent Changes in Law

Treasury added Article 28 to the New Model Treaty to address situations in which, after a treaty
is signed, one of the countries changes its corporate tax system to no longer impose significant
tax on cross-border income—either by adopting a territorial tax system or reducing the statutory
corporate tax rate below the lesser of (i) 15 percent or (ii) 60 percent of the general corporate tax
rate applicable in the other country. If such a change in law were to occur, following the requisite
consultation and provision of notice, treaty benefits would cease to have effect for payments of
dividends, interest, royalties, and other income. This rule represents a retreat from the harsher
version that appeared in Treasury's 2015 Drafts, which was not limited to corporate tax laws, did
not first require consultation, and would have been triggered solely by a drop in a country's tax
rate below 15 percent (regardless of the other country's tax rate).
In general, Treasury's position is that such a fundamental change of law could call into question
the original balance of negotiated benefits and the extent to which the treaty remains necessary to
eliminate double taxation (while increasing opportunities for low or no taxation). It is likely this
new rule reflects Treasury's concern that certain treaty partners that currently use rulings or other
special regimes to attract foreign investment may ultimately adopt low(er) rates across the board
in response to the BEPS Project and the European Commission's ongoing state aid
investigations. Practically speaking, this provision appears aggressively designed to try to
discourage treaty partners from doing this in the first place—or to at least force them to take the
treaty consequences into consideration before making such changes to domestic law.11

OECD BEPS recommendations

Article 5: Permanent Establishment: The 2016 Model made two changes to the 2006 Model
with regard to when a building site, construction or installation project triggers a permanent
establishment.

First, the term “exploitation of natural resources” now explicitly includes the exploitation of sea
beds and subsoil. Second, the 2016 Model adopts the OECD BEPS recommendation regarding
anti-fragmentation rules that prevent contract-splitting to meet the 12-month permanent
establishment threshold. The rule provides that when connected persons carry on activities that
are connected to a building site or construction or installation project in intervals of more than
30 days, those time periods are added to the periods of time in which the primary enterprise has
carried on activities at that construction or installation project. 12

Article 10: Dividends: The 2016 Model makes significant changes to the dividends article
contained in the 2006 Model in addition to the revised LOB provision and restrictions on
benefits to expatriated entities discussed above:

The 2016 Model maintains two preferential tax rates for dividends —5% and 15%. However, the
2016 Model adopts requirements from the OECD BEPS initiative that impose additional
ownership and residency requirements in order to obtain the 5% rate. The beneficial owner

11
Treasury Publishes Updated Model Income Tax Treaty https://www.jonesday.com/en/insights/2016/03/treasury-
publishes-updated-model-income-tax-treaty
12
Vega Borrego, The Special Tax Regimes Clause in the 2016 U.S. Model Income Tax Convention. Intertax. 2017
claiming the 5% rate must for a 12-month period ending on the date on which it is entitled to the
dividends: (1) be resident in the other contracting state or a qualifying third state; and, (2) own
at least 10% of the vote and value of the shares of the payor or a qualifying predecessor owner.
For the purposes of this requirement, the qualifying third state must be a state with a
comprehensive income tax treaty with the contracting state when the company paying the
dividend is resident and the rate must provide for a preferential 5% rate with similar terms. A
qualifying predecessor owner is any connected person who the beneficial owner of the
dividends acquired the shares from and such connected person was a connected person at the
time of acquisition. For the purposes of this test, a resident of a contracting state is considered
to directly own shares held by a fiscally transparent entity that is not resident of the other
contracting state in proportion to the company’s ownership interest in that entity. 13

Special tax regimes, inversions, arbitration

Another new rule denies tax treaty benefits for certain payments, including interest, royalties,
and guarantee fees, to a related person that benefits from a “special tax regime” with respect to
the income, he said.

Since the special tax regime results in a low rate of taxation in the taxpayer’s residence country,
it is consistent with Treasury’s treaty policy to deny treaty benefits on the ground that there is an
insufficient threat of double taxation.

The 2016 US model would also deny treaty benefits for certain payments, including dividends,
interest, royalties, and guarantee fees, by an ‘expatriated entity’ to a related person for a 10-year
period following the date of the corporate inversion transaction, he noted.

This rule is not so much about Treasury’s current treaty policy as it is about punishing
corporations that expatriate.

The new model also includes a provision mandatory arbitration. This is a “very welcome
addition,” she said. “Hopefully, over time, the inclusion of arbitration in treaties going forward

13
KPMG report: Initial analysis of 2016 U.S. model treaty
https://assets.kpmg.com/content/dam/kpmg/pdf/2016/02/tnf-us-16078print.pdf
will improve the treaty dispute resolution process, making it more likely that disputes will be
resolved in a relatively timely manner.

CONCLUSION

The 2016 Model has not addressed the issues raised by the OECD in BEPS Action Plan 1 with
respect to taxation in the digital economy (e.g., issues such as characterisation, nexus and taxable
presence).

The insertion of the new Article 28 – Subsequent Changes in Law, is a significant addition and
it will be interesting to see, practically, how the countries consult and determine the need for
amendments in their tax treaty, on account of beneficial tax treatment to residents under
domestic laws.

Although the LoB clause in the 2016 Model is very extensive, it will be interesting to see how
the countries incorporate such a clause in their tax treaties. The test for “primary place of
management and control” has been provided for listed and companies and headquarter
companies to qualify under the LoB clause. The definition of “primary place of management and
control” lays emphasis on exercise of day-to-day responsibility for more of the strategic,
financial and operational policy decisionmaking for the company and its direct/ indirect
subsidiaries. At this stage, it will be relevant to compare this to the term, “Place of Effective
Management”, introduced under Indian tax regulations, which lays emphasis on key
management and commercial decisions that are necessary for the conduct of business of an
entity as a whole. It will be interesting to see whether Indian tax regulators would import this
term in Indian tax regulations/ treaties.

It should be noted that the LoB clause in the BEPS report on Action Plan 6 is yet to be finalised
by the OECD, and it remains to be seen whether the OECD incorporates the changes in the 2016
Model LoB clause in Action Plan 6.
 REFERENCES

 Anthony Diosdi Unraveling The United States- India Income Tax Treaty, 2021
 Julie Martin, 2016 US model tax treaty differs significantly from draft version, MNE
TAX, 2016
 Kim Brooks, International Tax: Tax Treaties, (Halifax, Nova Scotia, 2020)
 Ross Mcdonald, "Time Present and Time Past": U.S. Anti-Treaty Shopping History,
Policy and Rules,American Bar Association, 2016
 Vega Borrego, The Special Tax Regimes Clause in the 2016 U.S. Model Income Tax
Convention. Intertax. 2017
 https://taxguru.in/income-tax/preamble-2016-model-income-tax-convention.html
 US Model Treaty 2016: What does it say about the US and
BEPS?https://kluwertaxblog.com/2016/02/21/us-model-treaty-2016-what-does-it-say-
about-the-us-and-beps/
 The 2016 Model Income Tax Treaty http://publications.ruchelaw.com/news/2016-
12/Insights-2015-YiR-Model-Treaties.pdf
 Treasury Publishes Updated Model Income Tax Treaty
https://www.jonesday.com/en/insights/2016/03/treasury-publishes-updated-model-
income-tax-treaty
 KPMG report: Initial analysis of 2016 U.S. model treaty
https://assets.kpmg.com/content/dam/kpmg/pdf/2016/02/tnf-us-16078print.pdf