Newsletter
Summary and Implication of the Amendment of Regulations Governing Application of Agreements for the Avoidance of Double Taxation with Respect to Taxes on Income
On August 12, 2021, the Ministry of Finance (the "MOF") announced the amendment to the Regulations Governing Application of Agreements for the Avoidance of Double Taxation with Respect to Taxes on Income (these "Regulations"), which has not been revised since the promulgation thereof in 2010. The amendment of the Regulations (the " Amendment") aims to overhaul the Regulations based on the MOF's practical experience from dealing with a variety of tax disputes over cross-border transactions in the past decade as well as the relevant recommendations provided in the Organisation for Economic Co-operation and Development (OECD)'s Base Erosion and Profit Shifting (BEPS) Progress Reports on Anti-Tax Avoidance Program, the OECD Model Tax Convention on Income and on Capital (the "OECD model tax treaty") and the Commentaries thereof, for the purpose of providing clarity on common disputes. The Amendment is expected to have significant impact on the current practice of applying for tax exemption in Taiwan under the prevailing tax treaties. The key points of the Amendment are summarized as follows:
1. Principal Purpose Test
To effectively prevent tax treaty abuse, the OECD amended the OECD model tax treaty in 2017 to include the "Principal Purpose Test" requirement in Article 29 (Entitlement to Benefits), under which the "Principal Purpose Test" is set forth in Paragraph 9 to specify that, when reviewing an application for obtaining a tax benefit under a certain tax treaty, such application shall not be granted by the tax authority if it is reasonable to conclude that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in such circumstances would be in accordance with the object and purpose of the relevant provisions of the tax treaty.
Ø A "directly" obtained tax benefit refers to the situation where a resident of another contracting state deliberately enters into a transaction or arrangement for the purpose of obtaining such benefits under the tax treaty. For example, in order to avoid the establishment of a permanent establishment in Taiwan, the resident of another contracting state may perform divisions of contract, activity or personnel without economic substance in Taiwan, so that its business operations would not technically be deemed a permanent establishment in Taiwan under the tax treaty, and may apply for tax exemption on its business profits.
Ø An "indirectly" obtained tax benefit refers to the situation where a person who deliberately enters into a transaction or arrangement for the purpose of obtaining a tax benefit that it would otherwise be unable to obtain based on its direct activities. For example, a resident of a third country that does not have a tax treaty with Taiwan establishes a paper company in a country that has a tax treaty with Taiwan, and indirectly receives a tax benefit under the treaty as a resident of country where the paper company was established, which is otherwise not available thereto from direct investment in Taiwan.
The purpose of the newly added Article 4.5 is to introduce the Principal Purpose Test to Taiwan.
Where a foreign entity engages in the divisions of contract, activity or personnel in Taiwan, the tax authority will verify whether such divisions are of economic substance or necessity to decide whether to grant the tax benefit under the applicable tax treaty.
In addition, whether or not a paper company has been established in a contracting state by the applicant for the sole purpose to enjoy the benefits of the tax treaty will also be considered by the tax authority based on the Principal Purpose Test.
Finally, it is important to determine whether one of the principal purposes of the transaction or arrangement is to obtain a direct or indirect benefit under the tax treaty, and whether the applicant has a commercially reasonable purpose for enter into such transaction or arrangement, taking into account the relevant facts and circumstances of the case.
Under the rules of Principal Purpose Test, the tax authority may deny a taxpayer the benefit of a tax treaty if the authority reasonably determines, in light of all relevant facts and circumstances, that the taxpayer has entered into an arrangement or transaction for the principal purpose of directly or indirectly obtain the tax benefit under the tax treaty.
2. Breaking of Deadlock
The Amendment also explains the scope of "Place of Effective Management (PEM)" by referring to Article 43-4 of the Income Tax Act, which states that when a legal entity has dual tax resident status in two countries, its Place of Effective Management will be the only place to which a tax treaty applies. The Place of Effective Management is determined by the following factors: (i) the place of management and decision-making activities; (ii) the place where the financial records and minutes of the board of directors and shareholders' meetings are kept; and 3. the place where the primary operational activities are carried out.
3. Determination regarding Existence of Permanent Establishment (PE) and Period of Business Activities
The Amendment makes reference to the OECD model tax treaty to specify the principles for determining the existence of a permanent establishment and the period of business operations and residence, and includes in the criteria for determining whether the activities engaged in for commercial purposes are related to and coherent with the specific geographical area. In other words, to determine whether a foreign entity has a permanent establishment in Taiwan, it is necessary to determine whether there is a specific location where the foreign entity can provide related services on a continuous basis. For example, if a foreign entity has been using the office premises of a Taiwan affiliate for a long period of time, in practice, it would most likely to be considered as having a permanent establishment in Taiwan.
It is important to note that even if a foreign consulting firm is not considered to have a permanent establishment in Taiwan, if the foreign consulting firm sends its staff to provide services in Taiwan for a period of longer than 183 days, it might still constitute a "service permanent establishment", which may affect the applicability of the tax exemption on its business profits.
4. Narrower Interpretation on Royalties
The Amendment also clarifies the scope of royalties in the application of the tax treaty, limiting them to the consideration paid for the use of industrial, trade, and scientific secrets where the furnishing party is not required to further customize or guarantee the benefits of their use.
In practice, there are controversies over whether the consideration for the use of private know-how to provide services to others is considered as "royalties" or "service fees". The Amendment also refers to the OECD model tax treaty in this regard. The "provision of information concerning industrial, commercial or scientific experience" refers to the case of authorizing others to use existing but undisclosed "know-how", which is different from the case of providing "services" to others by using the know-how or technology by oneself. The former is defined as royalties and is subject to the royalty provisions of the Income Tax Act; the latter is technical service income and should be treated in accordance with the applicable provisions of the tax treaty for operating profits, business execution or technical service fees.
Conclusion
Based on the scope and depth of the Amendment, it can be regarded as a positive response from the Taiwan tax authority to the international trend of tax-avoidance prevention. As long as this trend continues, the subsequent amendments to the applicable regulations and the intensity of supervision will only become more and more stringent. The Principal Purpose Test rule referred to above has been adopted as the minimum standard for the implementation of the Anti-Tax Avoidance Program in various countries, and international organizations (e.g., OECD, EU) have also included it as one of the criteria for reviewing the list of non-cooperative countries in taxation. Such rule is expected to have significance impact on the future application of tax benefits under tax treaties.
Lee and Li suggest that companies that would be affected by the Amendment should work with professional consultants as soon as possible to conduct a comprehensive risk assessment of their existing trading patterns and structures, as well as their future business development directions, in order to take appropriate countermeasures and keep an eye on subsequent developments of these Regulations in order to make timely adjustments of their business strategies.