The Relative Effect of International Agreements in Tax Treaties

Introduction

A Double Taxation Agreement, commonly referred to in Indonesia as a P3B, is essentially an international agreement governing the allocation of taxing rights between two States. In international tax practice, one important principle commonly associated with the application of tax treaties is the relative effect of international agreements. This principle is based on the notion that a treaty creates rights and obligations only for the parties that have agreed to be bound by it, while a third State is generally neither burdened with obligations nor automatically entitled to benefits under that treaty.

In public international law, this principle is known as pacta tertiis nec nocent nec prosunt. In general, it provides that a treaty should neither prejudice nor benefit a third party without an adequate legal basis. This principle was subsequently codified in Article 34 of the Vienna Convention on the Law of Treaties. If applied straightforwardly to tax treaties, the consequence is that treaty benefits or limitations on taxing rights are available only to persons that fall within the scope of the relevant treaty.

Does the Relative Effect Apply Absolutely to Tax Treaties?

Nevertheless, the application of the relative effect in the context of tax treaties cannot always be understood in absolute terms. Tax treaties differ from many other forms of international agreements because their provisions are directly connected with taxpayer status, sources of income, residence, and mechanisms for allocating taxing rights. In certain circumstances, a determination of status under one treaty may indirectly affect the tax treatment of a relationship involving another State.

One debate arose in the Commerzbank case. In that case, a view emerged that the principle of relative effect should not necessarily be applied rigidly to tax treaties. Where a tax treaty does not contain a provision expressly limiting the persons covered, it may theoretically be possible for a domestic taxpayer of a State that is not a party to the treaty to experience consequences arising from the application of that treaty. Similar views have also been discussed in international tax literature, including by academics who emphasize that a tax treaty should be interpreted according to the structure and purpose of each provision rather than solely by reference to the identity of the contracting States.

Dual-Resident Illustration and Its Effect on a Third State

The issue becomes particularly interesting where a company has dual-resident status.

For example, Company AB is incorporated under the laws of State A, but its place of effective management is located in State B. State A has tax treaties with both State B and State C, whereas State B and State C do not have a tax treaty with each other.

In such circumstances, the residence determination or tie-breaker rule under the treaty between State A and State B may determine the State in which Company AB is treated as resident for treaty purposes.

That determination may subsequently affect the treatment of dividends paid by Company C in State C to Company AB.

In other words, a conclusion reached under the treaty between State A and State B may have a practical effect on the amount of tax withheld on income arising from State C, even though State C is not a party to the treaty between State A and State B.

This situation demonstrates that the effect of a tax treaty does not necessarily end with the bilateral relationship between the contracting States.

In an interconnected international tax system, a status determined under one treaty may be used as a legal fact in applying another tax rule.

Accordingly, although a third State does not automatically acquire rights or obligations under a treaty to which it is not a party, the factual consequences of that treaty may still affect transactions involving that State.

Relationship with Persons Covered

The persons covered provision is particularly important in determining the extent to which treaty benefits may be used.

Tax treaties generally provide that the agreement applies to persons who are residents of one or both of the contracting States.

This provision acts as the entry point for determining who may access treaty benefits, including reduced withholding tax rates on dividends, interest, or royalties, or limitations on taxing rights over particular categories of income.

Where the scope of persons covered is expressly defined, the possibility of connecting treaty benefits with persons from a third State becomes more limited.

Conversely, where a treaty has an unusual structure or does not clearly restrict its scope, interpretation of the persons entitled to its benefits may become more complex.

In this context, a tax treaty cannot adequately be interpreted by examining one article in isolation.

Provisions concerning residence, beneficial ownership, permanent establishments, source of income, and methods for eliminating double taxation should be read as an integrated whole.

Criticism of the OECD Commentary Approach

The involvement of third States also arises in interpretations contained in the OECD Commentary, particularly in relation to residence status and the treatment of passive income.

However, the OECD approach has not been accepted without criticism.

A number of academics have questioned whether a status determined under a treaty between two States can legitimately be used as a basis for affecting the tax consequences of a relationship with a State that is not a party to that treaty.

The criticism is particularly concerned with whether such an interpretation is consistent with the original purpose of residence provisions and the taxation of passive income.

In practice, this issue illustrates the distinction between the direct legal effect of a treaty and factual or interpretative effects that arise because different treaty relationships are interconnected.

Direct legal effects bind only the parties, while indirect effects may arise when a status or fact determined under one treaty is used in applying domestic tax law or another tax treaty.

Implications for International Tax Practice

For taxpayers engaged in cross-border transactions, the issue of relative effect has important practical consequences.

Tax treaty analysis should not stop at the question of whether two States have entered into a tax treaty.

Ownership structures, residence status, place of effective management, the existence of a permanent establishment, payment flows, and treaty relationships among other States involved in the transaction structure may also affect the ultimate tax outcome.

This is particularly relevant for multinational group structures.

A company may receive income from several jurisdictions while simultaneously maintaining ownership relationships or business activities in other States.

A residence determination under one treaty may potentially affect withholding tax in the source State, the availability of foreign tax credits, and even the assessment of whether an entity is entitled to particular treaty benefits.

The analysis should therefore consider the substance of the transaction and the entire network of relevant treaty relationships.

In addition, developments in international anti-tax avoidance policy have made the use of tax treaties increasingly affected by provisions such as beneficial ownership, the principal purpose test, limitation on benefits provisions, and various Base Erosion and Profit Shifting measures.

Accordingly, even where a structure technically satisfies the initial textual requirements for treaty benefits, those benefits may still be denied where the structure was established primarily to obtain a tax benefit contrary to the purpose of the treaty.

Conclusion

The relative effect of international agreements remains a fundamental principle in understanding tax treaties.

As a general rule, a tax treaty binds the States that are parties to it and its benefits are intended for persons falling within the scope of the treaty.

In international tax practice, however, this principle does not always produce an entirely simple dividing line.

A status determined under one treaty may have indirect consequences for transactions involving a third State.

Tax treaty application should therefore not be viewed solely as a series of independent bilateral relationships.

A proper analysis must consider the interaction between provisions relating to persons covered, residence, source of income, tie-breaker rules, and the relevant network of tax treaties.

This approach is important to ensure that treaty benefits are applied correctly while remaining consistent with the fundamental purpose of tax treaties, namely eliminating double taxation without creating opportunities for inappropriate tax avoidance.

Relevant Legal Framework

• Vienna Convention on the Law of Treaties, particularly the principle concerning treaties and third parties.

• Tax treaty provisions governing persons covered, residence, tie-breaker rules, and the allocation of taxing rights over cross-border income.

• OECD Model Tax Convention and Commentary as interpretative references frequently used in international tax practice.

• International anti-tax avoidance principles, including developments relating to BEPS, beneficial ownership, and the principal purpose test.