Impact of Proposed Changes to Article 9 of OECD Model Tax Convention

Article 9 of the Organization for Economic Cooperation and Development (OECD) Model Tax Convention (the Convention) is the foundation of the transfer pricing (TP) concept applied by international tax systems. It fulfills the arm’s length principle that allows for a comparison between controlled and uncontrolled transactions relating to the taxation of profits of associated enterprises.

According to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) and the UN Practical Manual on Transfer Pricing for Developing Countries (UN Manual), enterprises are associated if one of the entities is directly or indirectly involved in the management, control, or capital of the other entity, or if one person from one of the entities participates directly or indirectly in the management, capital, or control of both entities.

The proposed change to the commentary on Article 9 (associated enterprises), as it relates to the implementation of domestic laws on interest deductibility, was developed by working parties 1 (a subgroup of the OECD Committee on Fiscal Affairs (CFA) in charge of the Model Tax Convention) and 6 (a CFA subgroup responsible for work on the taxation of multinational enterprises, covering TP matters), in collaboration with G-20 subcommittees.

This article analyzes the proposed change to the commentary on Article 9 which addresses profit adjustments that may be made for tax reasons in related party transactions that are not conducted on an arm’s-length basis. It also discusses the implications and effects of these proposed changes, as well as how foreign tax systems may react to them.

These suggestions, while not yet implemented, are being considered and will most likely be included in the next update of the Convention which is expected to be released in the near future.

Proposed Changes to Commentary on Article 9 of the Convention

Some of the proposed changes to the commentary, which aims to give specific guidance and clarification on the application of Article 9, are as follows:

• The addition of “and therefore the addition will not apply to the” and “In order to ensure the elimination of double taxation, the arm’s length principle and the guidance on its interpretation in the OECD Guidelines should be followed in any re-writing of accounts” to paragraph 1(2).
• The elimination of paragraph 1(3) on thin capitalization and replacement with “In considering whether an interest payment can be regarded as an arm’s length amount, a state will typically examine the terms and conditions of the loan such as the rate of interest. It may also need to examine, based on the facts and circumstances, whether a purported loan should be regarded as a loan or as another kind of transaction, in particular a contribution to equity capital. The state making a determination as to the extent to which the purported loan is regarded as a loan will do so taking into account factors discussed in its domestic laws (including judicial doctrine), or in the OECD Guidelines.”
• The inclusion of “Once the profits of the two enterprises have been allocated in accordance with the arm’s length principle, it is for the domestic law of each contracting state to determine whether and how such profits should be taxed, as long as there is conformity with the requirements of other provisions of the Convention. Article 9 does not deal with the issue of whether expenses are deductible when computing the taxable income of either enterprise. The conditions for the deductibility of expenses are a matter to be determined by domestic law, subject to the provisions of the Convention and, in particular, paragraph 4 of Article 24. Paragraph 30 of the Commentary on Article 7 makes an equivalent statement for the application of Article 7. Examples of domestic rules that can deny a deduction for expenses include certain rules on entertainment expenses and on interest such as those recommended in the final report on Action 4 of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project” as paragraph 1(3.1).
• The renumbering of the current paragraph 2(6.1) to (6.2) and the inclusion of the terms of the new paragraph 2(6.1) to read “As noted in paragraph 1(3.1) above, Article 9 applies only for the purposes of allocating profits to the two enterprises in accordance with the arm’s length principle. It does not deal with the subsequent computation of taxable income, which is a question of domestic law. Any mismatch in this domestic law treatment does not in itself result in economic double taxation for the purposes of paragraph 1(2), and there is thus no obligation on state B to make a corresponding adjustment in these circumstances.”

Implications of Proposed Changes to Commentary on Article 9

The commentary on Article 9 clearly explains that domestic tax authorities have the power, for the purpose of calculating the tax liabilities that arise out of a related party transaction, to re-write the accounts of entities if the accounts fail to show the true taxable profit derived from that transaction.

In such situations, modifications are only appropriate if there is a mutual understanding and agreement among the parties to the transaction that the existing circumstance does not fulfill the arm’s-length standard.

This paragraph further clarifies that such adjustments are allowed only under circumstances where the transaction has been confirmed as not being carried out in line with the arm’s-length principle.

Consequently, for the purposes of paragraph 1(2) of Article 9 of the Convention, a commensurate adjustment would not be required where transactions were conducted in accordance with the arm’s-length principle.

One major implication is that compliance with the arm’s-length principle and in effect the OECD Guidelines, is strongly emphasized. The power given to tax authorities to rewrite accounts will serve as a deterrent to multinational enterprises (MNEs) which engage in related party transactions outside of the arm’s-length principle. It also encourages the domestic tax authorities to conduct adequate checks and analysis before concluding that a controlled transaction has not been carried out at arm’s-length, thereby fostering a culture of adequate documentation in tax systems across the world.

Regardless of the powers granted to the tax authority, the proposed amendment aims to limit that authority by stating that when modifications to contracting nations’ accounts are required, the rules of the OECD principles shall be applied. This demonstrates that the domestic tax authority’s power is not absolute, but rather a consequence of necessity.

As a result, tax authorities should always use the arm’s-length principle as the legal basis for any tax assessment or re-characterization while carrying out this assignment.

In addition, these adjustments could easily result in misunderstanding and conflict between contracting states. However, the ability of tax authorities requesting an adjustment to prove that one is indeed required, and to push for mutual understanding and agreement among the states involved in the transaction, is important.

Further examination of this paragraph reveals that, unlike the compliance function, where taxpayers are responsible for proving the arm’s-length principle, the burden of proof will fall on the tax authorities to prove that a controlled transaction was not carried out in accordance with the arm’s-length principle. As a result, tax authorities will need to prepare explicit documentation and evidence to support their decision to rewrite accounts, as well as to demonstrate that rewriting accounts is essential to determining the taxable profit of associated enterprises or contracting states.

The OECD’s Transfer Pricing Guidance on Financial Transactions (the Guidance), which was published on Feb. 11, 2020, led to the update in paragraph 1(3) of Article 9. Accordingly, more emphasis is placed on the definition of a loan in deciding whether an interest payment or income, as the case may be, is at arm’s length.

This paragraph goes on to identify the considerations to examine when deciding whether a purported loan should be classified as a loan or as another type of transaction. In this case, we are not only looking at the interest rate and terms of the loan, but also at the accurate classification or delineation of the transaction. The restatement of the commentary appears to provide a larger range of options for assessing whether an amount of interest is at arm’s length.

The Guidance, in paragraph 10.13, depicted a scenario in which Company B gets an advance of funds from Company A that is classified as a loan, despite the fact that it is clear that Company B would not be able to service the loan due to its current financial condition. Based on this, the Guidance concluded that the delineation of the transaction as a loan violated the arm’s-length principle, and that the transaction will be regarded as a loan up to the amount that an unrelated third party is willing to advance to Company B, while the remainder is reclassified as a different type of transaction.

In the reclassification of a purported loan as an equity or any other type of transaction, the proposed commentary does not specify which legal authority takes precedence where the OECD Guidelines and domestic tax legislation are in dispute. This is in reaction to the use of the word “or” in the final paragraph of the proposed commentary. This paragraph suggests that, in terms of identifying the real nature of a loan transaction, local legislation and the OECD Guidelines are equal for the purposes of implementing Article 9.

Economic double taxation is more likely to occur where domestic techniques differ among states due to a lack of internationally accepted and unified financial terminologies. In such cases, the OECD Guidelines may take precedence. However, using more preferred wording like “and/with” might dispel any idea that local law and the OECD Guidelines are incompatible, as well as promote consensus between the two regulatory systems in the execution of the Guidance among OECD member states.

Any alternative approach that disregards an accurate characterization of the purported loan transaction would thus be in breach of the arm’s-length principle, as well as the applicable contracting state’s regulations.

On the flip side, while the proposed changes to paragraph 1(3) provide some clarity to the intent and purposes of the Convention in streamlining and thereby creating uniformity in MNE financing arrangements, it may limit MNEs’ ability to finance group members in the most efficient manner possible, as well as cause distortions in business structures and decision-making processes.

MNE members have a better knowledge of their group’s operations and how to best fund the group’s businesses. Reclassifications of transactions might thus be regarded as an interference in business structures, which could be detrimental to global business operations.

The update to paragraph 1(3.1) aims to provide clarification on the overall tax deductibility criteria under domestic regimes, in addition to assessing the arm’s-length nature of financial transactions. The major goal here is to guarantee that the provisions of the OECD Convention and the domestic TP regulations are consistent. It asserts that once a transaction between associated enterprises is priced at arm’s length, the conditions for tax deductibility are to be determined by domestic laws subject to the provisions of the Convention, meaning that tax authorities from different nations, systems and regimes must consult the articles of the Convention before making a concrete decision on tax deductibility.

This means that the rule of inclusivity should not be employed when interpreting the provisions of the Convention. Because a method of verifying tax deductibility does not appear to violate the arm’s-length principle, it does not follow that it is permitted by the Convention, especially when that same method is in direct conflict with another article.

Global Minimum Tax Rate

In general, if the proposed changes to the commentary on Article 9 are adopted, it is likely that more countries will support the idea of a global minimum tax rate, thereby pushing the agenda for international tax reforms and ensuring that MNEs pay a fair share of tax wherever they operate.

In July 2021, international leaders agreed to support a worldwide minimum corporate tax rate of at least 15% in order to discourage MNEs from transferring earnings to low-tax nations and tax havens to avoid paying taxes. Of the 139 nations engaged in the OECD/G-20 Inclusive Framework, 130 have already signed up to the agreement. The framework is designed to deter countries from engaging in tax competition by lowering tax rates that result in corporate profit shifting and tax base erosion.

If MNEs have little or no tax advantage from moving investments and profits to lower-tax jurisdictions as a result of a common minimum tax rate, economic competition between countries will be influenced more by the social welfare of their citizens and the implementation of sound economic policies. Governments around the globe will invest in innovative revenue-generating strategies to improve their efficiency in attracting investment.

With a global minimum tax in place, MNEs will no longer be able to pit countries against one another in a bid to push tax rates down. They will no longer be able to avoid paying their fair share by hiding profits generated in the U.S., or any other country, in lower-tax jurisdictions such as Hungary, Estonia, Nigeria and Kenya.

Conclusion

The proposed changes to Article 9 reaffirm the OECD’s commitment to promoting fair and equitable tax processes that cut across several national tax systems while maintaining global best practices.

These revisions will resolve several misunderstandings and contradictions in Article 9 as well as other concerns that have not been addressed previously. One example is the authority given to tax officials to rewrite accounts, which has addressed the problem of non-compliance with the arm’s-length principle.

In addition, the Convention makes provision for when there are disputes over the amount and nature of an account adjustment. Paragraph 2(11) of the Convention states that the appropriate means of adjudication is to implement paragraph 4, Article 25 (“the mutual adjustment procedure authorizes the competent authorities to communicate with each other directly, without going through diplomatic channels”).

Finally, the Convention has established a greater scope for matters to be considered in evaluating whether an amount of interest is at arm’s length by amending paragraph 3 of Article 9, which is consistent with the requirements of the Guidance.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Omojo Okwa is a manager and Akaoma Osele is a semi-senior adviser in the transfer pricing services practice of KPMG Advisory Services in Lagos, Nigeria.

The authors may be contacted at: omojo.adefila@ng.kpmg.com; akaoma.osele@ng.kpmg.com