Comprehensive Analysis of Issues Arising from the Extraterritorial Taxation of Dividend under Article 10(5) of the OECD Model Tax Convention

“Article 10(5) of OECD MTC looks small, but it enjoys a special treatment in international tax law.”

Organisation for Economic Cooperation and Development (OECD) commentary to the provision of Article 10(5) and its history is very illuminating. Article 10(5) of the OECD Model Tax Convention, 2017 (OECD MTC) has been defined “as a negative source rule.”1 The Source country should not tax the dividend distributed by a non-resident company to shareholders simply because such a non-resident company makes its corporate profit that is created in the source country. However, Article 10(5) contains two crucial exceptions.

With this background, the structure of this article makes an attempt, in the first section, to provide the historical aspects of Article 10(5) of the OECD MTC. Thereafter, the article discusses the principle of Article 10(5) which consists of the main rule of Article 10(5), exceptions to Article 10(5), and practical application of the triangular case. Further, this analysis takes a closer look at the application of Article 10(5) under specific scenarios such as the cash scenario, dual-residence scenario, and controlled foreign corporation (CFC) scenario. Each scenario has been discussed with the help of a flow chart.

The last section of this article seeks to discuss the treaty analysis in the context of interpreting Article 10(5), particularly:

  • (a) The provisions allowing a second layer of taxation on the profits attributable to a permanent establishment (“PE”) in the country in which the said PE is located; and
  • (b) The provisions allowing for the application of extraterritorial taxation.
1946
Origin: London Draft Art. VIII(3)
Rule
Negative Source Doctrine
2
Primary Treaty Exceptions
5% – 15%
Branch Profits Tax Caps

Evolution of Article 10(5) of the OECD MTC

  • Article 10(5) of the OECD MTC has its origin in Article VIII(3) of the London Draft MTC of the League of Nations of 1946.
  • On 1 August 1960, Working Party 2 of the Fiscal Committee submitted the final draft on Article 10 dealing with the taxation of dividends which was published on September 1, 1961, wherein the related commentary provided only limited guidance, in particular, that non-resident companies were not to be subjected to special taxes on undistributed profits.
  • From the OECD Draft (1963) onwards, the provision has been retained and its wording has been slightly amended without any change of its substance.2

The Principle of Article 10(5) of the OECD MTC

i. Statutory Extract from the OECD MTC, 2017

“Where a company which is a resident of a Contracting State derives profits or income from the other Contracting State, that other State may not impose any tax on the dividends paid by the company, except insofar as such dividends are paid to a resident of that other State or insofar as the holding in respect of which the dividends are paid is effectively connected with a PE situated in that other State, nor subject the company’s undistributed profits to a tax on the company’s undistributed profits, even if the dividends paid or the undistributed profits consist wholly or partly of profits or income arising in such other State.”

The provisions of the OECD MTC are similar to the provisions of the UN MTC. However, the OECD MTC does not refer to a ‘Fixed base’ as it covers only the Permanent Establishment (PE) situation.

ii. The Main Rule of Article 10(5)

  • As per Article 10(5), the source country should not tax the dividend distributed by a non-resident company to shareholders merely because such a non-resident company derives its corporate profit that originated in the source country.
  • Source of dividends is not the state in which the profits out of which dividends are paid were derived.
  • For example, in Picture 1, X Co. is a resident, on the basis of Articles 3 and 4 of the OECD MTC, in a contracting state i.e., State X; and the profits are derived by that company from the other contracting state i.e., State Y.
  • In such a case, State Y is not entitled to tax the dividends paid by X Co. and subject the undistributed profits of the company to tax, regardless of the fact that the profits relate to income arising in the other contracting state i.e., State Y.
  • In this way, Article 10(5) prohibits ‘extraterritoriality’ with respect to the taxation of dividends, and this interpretation is confirmed by the Commentary on Article 10 paragraph 33 of the OECD MTC, 2017.
  • Further, this article also prohibits the country of source from taxing undistributed profits of a company that is a resident of another country, even if the profits were wholly, mainly, or partly derived from sources within the country of source.
  • Special taxes on undistributed profits are also prohibited; in other words, non-resident companies are not to be subjected to special taxes on undistributed profits.3
Picture 1: General Case — Prohibition of Extraterritorial Taxation
State X
X Co. (Resident)
⤹ Profit Sourced ⤸
State Y
(Source State)
Result: State Y is NOT entitled to tax dividends paid by X Co., nor tax its undistributed profits.

iii. Triangular Case

As Article 10(5) does not clearly indicate where the recipient must be located, there may be situations involving three states:

For example, in Picture 2, X Co. and Z Co. are residents in State X and State Z respectively. Dividends are paid by a resident of State X to a resident of State Z. X Co. carries on its business in State Y. It also generates income from State Y through a Permanent Establishment (PE) in State Y.

Picture 2: Triangular Case Structural Configuration
State X
X Co. (Payor Co.)
─── Dividend Paid ───►
State Z
Z Co. (Shareholder)
│ Branch / PE
State Y
PE of X Co. (Business Activity)
Interaction of 3 Bilateral Treaties: State X–Z, State Y–Z, and State X–Y

In such a case, the following three tax treaties may apply:

Contracting StateTax Treaty: State X & State ZTax Treaty: State Y & State ZTax Treaty: State X & State Y
1. State Z• Z Co. is a resident recipient of the income.
• According to Article 7(4) of the OECD MTC, Article 10 takes priority over Article 7.
• State Z can also tax its resident recipient i.e., Z Co., but must grant double tax relief.		In this scenario Article 10 does not apply as the dividends are not paid by a resident of State Y.
• Articles 7 or 21 apply, both attributing taxing rights to State Z.		—
2. State X• X Co. can tax the distribution of dividends at source, but subject to the withholding limitations of the tax treaty.——
3. State Y——• State Y would be prohibited from taxing the distribution of dividends by X Co.
• State Y is not entitled to:
  1. Tax the dividends paid by X Co.
  2. Subject the undistributed profits of the company to tax, regardless of the fact that profits relate to income arising in State Y.
Table: Three-Way Treaty Interaction in a Triangular Case; Source: Author’s Analysis

iv. The Exceptions to Article 10(5)

Article 10(5) provides for two specific exceptions:

Exception 1: Dividends Paid to a Resident of the Other Contracting State

Where the dividends are paid to a resident of the other contracting state (e.g., dividends paid by X Co. in State X to Y Co. in State Y). Under this first exception, State Y should not be limited by Article 10(5), as it is taxing its own resident (Y Co.) under residence-based worldwide taxation, and is not claiming source jurisdiction over foreign company profits.

Picture 3: Exception 1 — Dividends Paid to a Resident of the Other State
State X
X Co. (Payor Co.)
─── Dividend Paid ───►
State Y
Y Co. (Resident Recipient)
State Y taxes its own resident Y Co.; Article 10(5) negative source rule does not restrict State Y.

Exception 2: Holding Effectively Connected with a Permanent Establishment

Where the dividends are paid to a company that has a PE in the other contracting state, and the holding from which the entitlement to receive dividends arises is effectively connected to the PE. With regard to this second exception, the same result would have been realized through the application of Article 7. In such a case, it is clear that despite the fact that it is apparently a domestic situation, the dividends should be attributed to the PE of X1 Co. in State Y for the purpose of determining its tax base.4

Picture 4: Exception 2 — Dividends Effectively Connected with a PE
State X
X1 Co. (Subsidiary)
─── Dividend Paid ───►
State X
X Co. (Head Office)
│ Holding Effectively Connected
State Y
PE of X Co. (Tax Base includes Dividends)
Dividends are attributed to State Y PE under Article 7 principles.

Application of Article 10(5) under Specific Scenarios

i. Cash Scenario

There could be a situation when a contracting state wants to tax a distribution of dividends by a company resident in another contracting state only because the cash necessary for the payment accrued and the subsequent payment is affected in its territory, i.e., through an account maintained there. Three possible cases arise:

Scenario CaseStructural Facts & Parties InvolvedCash Remittance ExecutionTreaty Resolution & Article 10(5) Interplay
Case 1
(Picture 5)		X Co. is resident in State X. Dividends are paid by X Co. to a resident of State X (P Co.).The cash flow execution of the dividend is made from a bank account in State Y to P Co.Article 10(5) of the State X–State Y treaty is not necessarily relevant. Articles 7 or 21 apply, giving exclusive taxing rights to State X.
Case 2
(Picture 6)		X Co. is resident in State X. Dividends are paid by X Co. to a resident of State Y (P Co.).The cash flow execution of the dividend is made from a bank account in State Y to P Co.The first exception in Article 10(5) of the State X–State Y treaty applies, arriving at the same result as Article 10 general rules.
Case 3
(Picture 7)		X Co. is resident in State X. Dividends are paid by X Co. to a resident of third State Z (P Co.).The cash flow execution of the dividend is made from a bank account in State Y to P Co. in State Z.Article 10(5) of the State X–State Y treaty can be directly invoked to resolve the issue and bar State Y from taxing.
Analysis of Cash Routing Scenarios; Source: Author’s Formulation

Conclusion in the Cash Scenario:

  • In case of a cash scenario, there could be situations in which a taxpayer would be insufficiently protected by a treaty network.
  • In Case 3 (Picture 7), according to State Z, Article 10(5) of the State X–State Y Tax Treaty would prevent State Y from levying extraterritorial tax, but according to State Y, the same provision does not affect its right to tax P Co., which could be disadvantaged from such an interpretation conflict.

ii. Dual-Residence Scenario

A dual-resident company is a company that is considered to be a resident of two contracting states according to their respective domestic tax laws (e.g., incorporation in one State, place of effective management in another). Three possible cases may arise:

  • Case 1 (Picture 8): Residence conflict is resolved in favour of State X (Winning State); State Y is the Losing State. Dividends are paid by a resident of State X to a resident of loser State Y (P Co.). 
    Resolution: Article 10 applies. The “winning” State X may tax dividends up to treaty caps. The “losing” State Y may tax dividends in the hands of P Co. as its resident, but must provide relief according to Article 23A or 23B.
  • Case 2 (Picture 9): Residence conflict resolved in favour of State X (Winning State). Dividends paid by a resident of State X to a resident of winner State X (P Co.). 
    Resolution: Article 10 does not apply (purely domestic to State X). The solution is found in Articles 7 or 21 of the OECD MTC. State Y has no taxing rights.
  • Case 3 (Picture 10): Residence conflict resolved in favour of State X (Winning State). Dividends paid by a resident of State X to a resident of third State Z (P Co.). 
    Resolution: If no profits are derived from State Y, Article 10(5) should not apply.

Key Principles Governing Dual-Residency Companies:

  1. Exception to Article 1: The provision of Article 10(5) is considered as an exception to Article 1 of the OECD MTC as there is no resident recipient of the income.
  2. Incorporation Principle Conflict: Article 10(5) is applicable in the dual-residence scenario where taxation is levied on dividends because of the incorporation principle under the domestic law of the country losing the tie-breaker. The fact that the winning country does not derive profits from the losing country, or that dividends were paid out of profits not arising in the losing country, is not relevant.

iii. Controlled Foreign Corporation (CFC) Scenario

CFC rules are the rules by means of which countries try to prevent the tax deferral of profits that normally would have arisen and been taxed in the relevant country.

Article 10(5) should only apply when the country applying the CFC rules derives profits from the CFC country. Paragraph 37 of Article 10(5) of the OECD Commentary provides that:

  • It cannot be interpreted as preventing the state of residence of a taxpayer from taxing that taxpayer, pursuant to its CFC legislation, on profits which have not been distributed by a foreign company.
  • The paragraph is confined to taxation at source and, thus, has no bearing on taxation at residence under such legislation or rules.
  • The paragraph concerns only the taxation of the company and not that of the shareholder.

Hence, Article 10(5) should be confined to taxation at source, but can, nevertheless, prevent the application of CFC rules “because the CFC legislation taxes all the profits of the CFC because of tainted income that has its source in the country imposing the CFC legislation.”

Treaty Analysis in the Context of Interpreting Article 10(5)

Most countries include a provision that is in line with Article 10(5), but also include another provision that allows for a second layer of taxation on the profits attributable to a PE in the country in which the said PE is located (often termed a Branch Profits Tax).

i. Provisions Allowing for a Second Layer of Taxation on PE Profits

Sl.Tax Treaty BetweenIn Line with Art. 10(5)?Second Layer of Taxation?Allow Extraterritorial Taxation?Relevant Extract of Treaty
1Canada – FranceYesYes (PE profits)No“Nothing in the Convention shall prevent a Contracting State from imposing on the earnings attributable to a PE, situated in that State, of a company which is a resident of the other Contracting State a tax in addition to the tax allowable under the other provisions of the Convention, provided that any additional tax so imposed shall not exceed 5 per cent of the amount of such earnings....”
2Costa Rica – SpainYesYes (PE profits)No“Profits of a company of a Contracting State which carries on business in the other Contracting State through a PE situated therein may, after having been charged to tax by virtue of Article 7, be taxed on the remaining amount in the Contracting State in which the PE is situated and according to the laws of that State, but in that case the tax charged shall not exceed 5%.”
Table: Bilateral Treaties Permitting Branch Profits Tax on PEs

ii. Provisions Allowing for the Application of Extraterritorial Taxation

Sl.Tax Treaty BetweenIn Line with Art. 10(5)?Second Layer of Taxation?Allow Extraterritorial Taxation?Relevant Extract of Treaty
1France – African StatesNo—Yes (Apportioned Base)“Where a company resident in one of the Contracting States is subject in that State to a tax on dividend distributions and maintains one or more PE in the other Contracting State in respect of which it may also be liable in the latter State to a similar tax then the income which may be subject to that tax will be apportioned between the two States in order to avoid double taxation.”
2Brazil – ItalyNo—Yes (PE WHT)“Where a resident of Italy has a PE in Brazil, this PE may be subject to tax withheld at source in accordance with a Brazilian law. However, such a tax cannot exceed 15 percent of the gross amount of the profits of that PE, determined after the payment of the corporate tax related to such profits.”
3Austria – CanadaNo—Yes (Carve-Out)“Where a company is a resident of a Contracting State the other Contracting State may not impose any tax on the dividends paid by the company to persons who are not residents of that other State, or subject the company to a tax on undistributed profits, even if the dividends paid or the undistributed profits consist wholly or partly of profits or income arising in such other State. The provisions of this paragraph shall not prevent that other State from taxing dividends relating to a holding which is effectively connected with a PE, or a fixed base operated in that other State.”
Table: Bilateral Treaties Incorporating Express Extraterritorial Apportionment Clauses

Concluding Remarks

Article 10(5) of the OECD MTC looks small, but it enjoys special treatment in international tax law. Many contracting states have tried to answer the questions connected to Article 10(5) by including specific provisions in their treaties aimed at clarifying whether or not the provision should be applied in certain situations.

Some tax treaties do not include the phrase “derives profit from” in order to make it clear that the application of the provision is not confined to situations of taxation at source and that, therefore, all forms of extraterritorial taxation are, in principle, prohibited. Other treaties include deviations related to the effects of Article 10(5) in regard to a dual-resident company, and the application of Article 10(5) is explicitly excluded.

In conclusion, it can be observed that those countries that provide for extraterritorial taxation of dividends have tried to include, in their tax treaties, a special provision in order not to be restricted by Article 10(5). However, evolution and increasing complexity of business models has led to recognition by the OECD that the wording of Article 10(5) of the OECD MTC could lead to absurd conclusions and therefore, it should be interpreted having in mind the purpose of the provision i.e., the prohibition of extraterritorial taxation and the fundamental purpose of a tax treaty, i.e., the avoidance of double taxation.

Statutory & Academic Footnotes

  1. J.F. Avery Jones et al., Tax Treaty Problems Related to Source, 38 Eur. Taxn. 3, sec. II.B. (1998), Journals IBFD.
  2. K. Vogel, Klaus Vogel on Double Taxation Conventions, p. 693 (Kluwer Law International, 1997).
  3. Commentary on Article 10(5), Paragraph 36 of the OECD Model Tax Convention, 2017.
  4. E. Arruda Madeira & T. Cassiano Nieves, Exploring the Boundaries of the Application of Article 10(5) of the OECD MTC, 35 Intertax 8/9, p. 474 (2007).