Tolley® Exam Training

PRACTICE EXAMINATION

ADIT PAPER 1

PRINCIPLES OF INTERNATIONAL TAXATION

ANSWERS

2020 SITTINGS

E761A
Note: in all cases your answers should be in essay format. To score well in Paper 1 it is
important that your essay is well constructed and addresses all aspects of the
question set. The answers below give guidance in respect of the areas that you should
have covered - they are not prescriptive neither are they exhaustive.

The marking guides are provided for illustration purposes only. A fixed marking
schedule is not followed - all essays will be awarded marks according to their content,
structure and relevance to the questions being answered.

1. DOUBLE TAXATION AGREEMENTS

To score well on this question it is important that you have written a well
structured and balanced essay. The question contained some key words
“nature”, “purposes” and “interpretation” - to write a good essay you need to
focus on these words from the question when structuring your essay.

Introduction

A few lines on why we have double tax treaties, to help resolve double taxation issues
which might otherwise arise in cross border scenarios. In a world where people,
companies and businesses move and operate in global markets, double taxation is
more likely when the various domestic tax rules of different states interact. However,
such treaties are complex as they need to consider both domestic and international tax
principles.

You should then discuss the different aspects of double tax agreements:

Nature

 Dual status, i.e. creating international obligations between states and being
incorporated into domestic law to confer rights on taxpayers

 How they are incorporated into domestic law, i.e. automatic, parliamentary
approval, legislation

 Hierarchy between treaty and domestic law, i.e. whether there is treaty override,
constitutional provisions which enable or preclude override, intentional and
unintentional override, how a contracting state may react to another state’s
unilateral override

 Example of case law: Commerzbank AG [1990]. Regarding primacy of the treaty

over domestic law reference might also be made to the cases Schneider Electric
SA (June 2002, No 232276), and the case of a German PE of a US LLC (No 8K
2541/12 G, 18 ITLR 363)

Purposes

 Avoid double taxation – example: tie breaker in Article 4 of OECD Model, and
also in UN Model and US Model; any article which allocates taxing rights

 Promote and facilitate trade and investment

 Mitigate the risks of under-taxation of taxpayers by promoting cooperation and

exchange of information

 Counteract tax avoidance and tax evasion – this aspect of double tax treaties
has become particularly relevant in a post-BEPS environment

 Prevent discrimination against non-residents and foreign nationals – example,

Article 24 in the OECD Model

© RELX (UK) Limited 2020 1 2020 Sittings

  Provide certainty for taxpayers (treaties have an average life of 15 years)

 Mutual cooperation in the resolution of disputes

 Examples: use of double tax conventions as part of BEPS Project and Action
Plan to combat base erosion and profit shifting – specific examples, such as the
amendment to the preamble in the 2017 OECD Model to refer to combatting
treaty shopping, similar in the 2016 US Model; amendments in the 2017 OECD
Model which now includes anti-avoidance provisions such as a Principle Purpose
Test (PPT) and Limitation of Benefit (LOB) article

 Other anti-avoidance provisions in a treaty: beneficial ownership requirements in

treaties; LOB article in the US Model, and Article 29 in the 2017 OECD Model,
which in addition to the PPT and LOB clauses also includes a Permanent
Establishment triangulation provision

Interpretation

 Order of interpretation, i.e. is term defined in treaty? If not, what is domestic

meaning? Domestic meaning of which state? Does context of treaty require
interpretation different from domestic meaning?

 Articles 31-33 Vienna Convention on the Law of Treaties

 Aids to interpretation, i.e. general and specific definitions within treaty, Article 3
(2) stating that domestic meaning may be used, role of OECD Commentary to
Model (including ambulatory/ static approach to its use, particularly relevant with
the updated post BEPS 2017 version of the Model Treaty and Commentary)

 The approach of different jurisdictions to the interpretation of double tax

conventions

 EU development – ECJ interpretation of a double tax treaty in 2017 case Austria

v Germany

 Reasons for apparent dichotomy between rules of interpretation for treaties and
approach to interpreting domestic legislation

 Role and approach of courts to interpreting double tax conventions (might refer
to the UK courts’ approach as set out in the Commerzbank AG case)

 Examples from case law, there are many cases which might be used for
illustration e.g. Fothergill v Monarch Airlines Ltd [1981] CIR v Commerzbank AG
[1990] STC 285, Bayfine [2011], Macklin [2015], Anson (formerly Swift) [2015],
Fowler [2017], State Secretary of Finance v X [2017] – Dutch Supreme Court,
Alta Energy Luxembourg SARL [2018] – Tax Court of Canada.

Conclusion

A few lines to bring it all together, stress how important treaties are for global
cooperation in tax matters.

© RELX (UK) Limited 2020 2 2020 Sittings

 MARKING SCHEME

MARKS
Introduction 1
Nature including:
Dual status
Incorporation into domestic law
Hierarchy – treaty vs domestic
Relevant cases 6
Purposes including:
Facilitate trade
Counter tax avoidance
Prevent discrimination
Certainty
Cooperation 6
Interpretation including:
Order 2
Aids to interpretation – VCLT 3
Different jurisdictions
– Dichotomy 2
Role of courts
– Relevant case law 6
Conclusion 1
TOTAL (MAX) 25

© RELX (UK) Limited 2020 3 2020 Sittings

2. CONNECTING FACTORS

Introduction: cover some basics, taxing rights links to jurisdiction of a state. Split
answer to cover the two areas raised in the question.

The first part of this question is concerned with the various ways in which states seek to
establish the jurisdiction to tax/right to tax the profits of multinational enterprises. In
other words, what ‘connecting factors’ may be used to establish a sufficient link
between the state and such taxpayers to warrant the imposition of tax?

This requires an examination of the traditional distinction between residence and

source jurisdiction, and of the fiscal consequences for the taxpayer (particularly, as to
the extent of any liability to tax) if jurisdiction is established under either of these heads.

In this respect, it might be expected that particular attention will be given to the manner
in which ‘residence’ of corporations may be determined for the purpose of establishing
residence jurisdiction i.e. principally through the place of incorporation and place of
management tests. Reference might also be made, in the context of individuals, to the
occasional use by states of ‘nationality’ or ‘citizenship’ to establish jurisdiction to tax (for
example, the US uses citizenship). This might impact on the operations of a
multinational depending on structure (and possible use of non corporate entities).

Discussion of source might include the taxation of some assets on a situs basis, for
example, or a discussion of how business/ investment income is taxed. Some (limited)
consideration may be given to the concept of a ‘Permanent Establishment’ in the
context of source jurisdiction.

This discussion might be followed by an examination of unitary taxation/formulary

apportionment, and by an analysis of its viability as an alternative to the traditional
approach to the taxation of the profits of multinational enterprises.

Credit may also be given to candidates who allude to the view (expressed, for example,
by Knechtle and Qureshi) that public international law does not impose limits on a
state’s jurisdiction to tax.

The second part of the question requires an initial explanation of the nature of double
taxation and, consequently, of the difference between juridical and economic double
taxation. This should be followed by illustrations of how conflicting claims to jurisdiction
e.g. residence/source can give rise to double taxation (with examples).

A treaty can resolve such issues: reference can be made to the tie-breaker rules set
out in Article 4 of the OECD Model Treaty, including the changes to Article 4(3) under
the BEPS Project, found in the 2017 version of the treaty – applying a mutual
agreement procedure – which resolves the residence-residence conflict. Article 7 of
the OECD Model provides another example as it allocates taxing rights with regard to
Permanent Establishments, which resolves the source-residence issue arising.

Conclusion: a few lines to round off discussions, showing the importance of double tax
treaties in resolving these issues.

MARKING SCHEME

MARKS
Introduction 2
What are connecting factors 6
Examples 4
Alternatives – unitary 3
How DT arises: juridical vs economic - examples 4
Treaty resolution: examples of each: Art 4 Tie-breaker clause can resolve
res-res issue; Art 7 can resolve res-source issue 4
Conclusion 2
TOTAL 25

© RELX (UK) Limited 2020 4 2020 Sittings

3. TRANSFER PRICING

To score well in this question it is important that your answer follows the
requirements - making comparisons between the various methods available -
rather than just outlining the methods set down in the OECD Transfer Pricing
Guidelines. In addition you need to address the importance of comparability and
objectivity in the calculations.

The methods that should be covered in your essay are CUP, resale price, cost plus,
transactional net margin and profit split method. A brief overview of the methods, as
follows, would be appropriate:

The CUP Method compares the price charged for property or services transferred in a
controlled transaction to the price charged for property or services transferred in a
comparable uncontrolled transaction in comparable circumstances. If there is any
difference between the two prices, this may indicate that the conditions of the
transaction between the associated enterprises are not arm’s length, and that the price
in the uncontrolled transaction may need to be substituted for the price in the controlled
transaction.

The Resale Price Method begins with the price for the sale to an independent party -
where the product has previously been purchased from an associated enterprise. This
price (the “resale price”) is then reduced by an appropriate gross margin (the “resale
price margin”), determined by reference to gross margins in comparable uncontrolled
transactions. The margin represents the amount out of which the reseller would seek
to cover its costs of goods, selling and other operating expenses and also make an
appropriate profit. What is left after subtracting the gross margin (and after adjustment
for other costs e.g. customs duties), is the arm’s length price for the original transfer of
property between the associated enterprises.

The Cost Plus Method begins with the costs incurred by the supplier in a controlled
transaction for goods/services provided to an associated enterprise. An appropriate
mark-up, determined by reference to the mark-up earned by suppliers in comparable
uncontrolled transactions, is then added to these costs, to make an appropriate profit in
light of the functions performed and the market conditions. It is important to ensure that
the cost base used reflects the functions performed and is in line with that of the
uncontrolled transactions. Candidates might refer to the simplified low value-adding
intra-group services approach in the updated 2017 TPG (post BEPS) which suggests a
set mark up of 5% on relevant costs, applied to a certain pool of costs identified for the
group (such as IT, HR services etc).

The Transactional Net Margin Method examines a net profit indicator, i.e. a ratio of net
profit relative to an appropriate base (e.g. costs, sales, assets), that a taxpayer realises
from a controlled transaction (or from transactions that are appropriate to aggregate)
with the net profit earned in comparable uncontrolled transactions (these may be
internal or external comparables).

The Transactional Profit Split Method first identifies the combined profits to be split for
the associated enterprises from the controlled transactions in which the associated
enterprises are engaged. It then splits the combined profits between the associated
enterprises on an economically valid basis that approximates the division of profits that
would have been anticipated between independent enterprises.

Pursuant to the BEPS project, the profit split approaches have been re-examined.
Updated commentary paragraphs were issued in June 2018 which note that the
determination of appropriate profit splitting factor(s) should reflect the key contributions
to value in relation to the transaction. Profit splitting factors based on assets, capital or
costs may be used where these capture the relative contributions of the parties to the
profits being split and they can be measured reliably. Notably whilst costs may be a
poor measure of the value of intangibles contributed, the relative costs incurred by
parties may provide a reasonable proxy for the relative value of those contributions.

© RELX (UK) Limited 2020 5 2020 Sittings

 Examples of each method may be given where appropriate, and you answer should
compare methods, and state why a particular one may be appropriate or preferable to
another method.

Your answer should make reference to the 2017 Transfer Pricing Guidelines (TPG), as
updated post BEPS, making particular reference to the following:

 The TPG do not lay down a hierarchy of methods;

 The TPG stress the importance of selecting the most appropriate method to the
circumstances of the case;

 The TPG contain an updated chapter on comparability analysis giving more

detail on how it is to be applied;

 The TPG contain additional guidance on how to apply the transactional profits
methods, with various annexes to Chapter II;

 The chapter on intangibles has been updated in the 2017 TPG, post the BEPS
Project, to make it more relevant and applicable to the position and use of
intangibles in the modern environment;

 The TPG include an updated chapter on business restructuring; and

 How transfer pricing should be applied.

Mention could be made that post the BEPS Project many changes to the TPG have
been introduced – Action Points on TP – 8, 9 and 10, in particular which reference
matters such as the transfer pricing of intangibles and the issues this creates (due to
the nature of intangibles). Changes have also been made with regard to the chapter on
cost contribution arrangements, low value-adding intra-group services (as noted), and a
re-written chapter on documentation, including the requirement for county-by-country
reporting for large groups (with turnover > €750 m).

MARKING SCHEME

MARKS
Introduction – lead into Guidelines etc. 1
Five methods:
CUP 3
Resale Price 3
Cost plus 3
TNMM 3
Profit Split 3
Comparability / objectivity 2
Discussion of the updated post BEPS guidelines – highlight key points 7
TOTAL 25

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4. POWERCO

PART 1: Consequences of the four suggested modes of operation

Establish a subsidiary and manufacture under licence

Under the provisions of Article 7, Powerco is not taxable on its business profits in State
B unless it has a Permanent Establishment (PE) in that state.

Does the subsidiary constitute a PE? Not in itself. It is a legally separate entity and as
such distinguished from a branch. Article 5(7) OECD Model makes this clear. Hence
prima facie the subsidiary is separately taxable in State B on its profits and Powerco
remains taxable only in State A. However, great care is required to ensure the
subsidiary does not become a PE of Powerco.

There are two risks:

 The subsidiary has a fixed place of business for Powerco under Article 5(1).
Does the subsidiary regularly make premises available for visiting staff of
Powerco? If so, the subsidiary could constitute a fixed place of business of
Powerco even though no formal legal right existed on the part of Powerco (2017
Commentary on Article 5 para 12). Simply seconding staff for a significant time to
monitor the activity of the newly formed subsidiary could make the subsidiary a
PE of Powerco (2017 Commentary on Article 5 para 15).

 Does the subsidiary constitute a dependent agent of Powerco under Article 5(5)?
Such a dependent agent can be an individual or a company (2017 Commentary
on Article 5 para 83). Does the subsidiary have and regularly exercise the
authority to contract on behalf of Powerco? (first element in Article 5(5)). The
contracts must relate to the core business of Powerco and not simply a
preparatory or auxiliary activity. Hence engaging staff on behalf of Powerco
would not constitute it a PE of Powerco (2017 Commentary on Article 5(5), para
85).

Sales by the subsidiary of its own products manufactured under licence from
Powerco would not be sales on behalf of Powerco, because of the legal
separation of parent and subsidiary recognised in Article 5(7).

However, if ever the subsidiary acted as a sales outlet for products produced by
Powerco and not the subsidiary itself, this would make the subsidiary an agency
PE of Powerco. The subsidiary would not formally need to sign contracts on
behalf of Powerco. The orders do not need to be finally concluded. It is notable
that the updated version of the agency PE concept in the 2017 OECD Model, per
Article 5(5) post the BEPS project, is more widely drafted and so includes
situations where the intermediary “habitually plays the principal role leading to
the conclusion of contracts that are routinely concluded without material
modification” by the overseas company.

In addition the activity of an intermediary that results in contracts for the transfer
of ownership, or the granting of the right to use, property owned by the non-
resident enterprise, or for the provision of services by the non-resident, would
also create an agency PE. It is very likely that if the subsidiary acted in the
capacity of a sales outlet, with staff arranging for the sale of Powerco products,
then an agency PE would be created under this new updated version of Article
5(5).

Will State B recognise the licence fee paid by the subsidiary as constituting an arm’s
length price? The subsidiary would need to demonstrate that it had undertaken a
transfer pricing study and complied with documentation formalities in State B. If not,
State B is likely to seek to adjust the price downwards under Article 9 principles (read
with the OECD Transfer Pricing Guidelines) by focusing on functions performed, assets
used and risks assumed by the subsidiary in State B. The result would be an increased

© RELX (UK) Limited 2020 7 2020 Sittings

 taxable profit for the subsidiary in State B at the higher rates prevailing there.
Consideration should be given to reaching an advance pricing agreement or other form
of informal clearance with the tax authority of State B.

Hence subject to care being taken not to have a PE in State B, and State B recognising
the licence fee as a correct arm’s length price, the contract manufacturing and licence
operation can be effective to reduce tax in State B. The licence fee would reduce profits
of the subsidiary and render the fee taxable at the lower rate in State A.

Own factory and sales team in State B

Here there is no question that Powerco has a PE under both Articles 5(1) and 5(5). The
factory constitutes a fixed place of business of Powerco in State B. The sales team will
also constitute dependent agents under Article 5(5). Strictly, once the presence of a
fixed PE has been established then there is no need to examine whether there is an
agency PE. Neither manufacture nor sales are preparatory or auxiliary activities under
Article 5(4).

The profits generated by the factory and sales team will thus be taxable in State B
under the ‘Authorised OECD Approach’ (AOA) by hypothesising the factory and sales
team as a distinct and separate entity.

This approach is therefore likely to produce to a higher tax liability. There is no scope
for a licence fee between head office in State A and branch in State B, as they are
legally a single entity. Therefore there is no opportunity to mitigate tax in State B to take
account of the intellectual property already generated by Powerco prior to establishing
its business in State B.

Export to State B, selling through local sales team and warehouse

At first glance the warehouse does not appear on its own to create a PE producing a
taxable presence in State B. It is “a store of goods” specifically exempted under the
examples of preparatory or auxiliary activities in Article 5(4). However the updated
2017 OECD Model version of Article 5(4) needs to be considered, as there is another
possible PE presence in State B.

It is assumed the sales team will have geographically separate premises and be
contracting in the name of Powerco as economically dependent agents. This will
therefore constitute a PE under both Articles 5(1) and 5(5).

Under the 2017 Model, with regard to Article 5(4), it is possible that the warehouse and
sales team would be considered together as they are complementary functions that
would form a cohesive business operation, rather than as two separate arrangements -
the updated version of Article 5, which has a new paragraph 4.1, contains an anti-
fragmentation rule with regard to preparatory and auxiliary activities.

Therefore the profits on sales in State B will become taxable there. Under the latest
March 2018 guidance issued on Article 5(4.1) the separate sales team and warehouse
would be taken as creating two PEs, with each being a distinct and separate entity (see
example one in the guidance). The profits would then be determined using transfer
pricing principles (the AOA). This will necessarily produce lower taxable profits in State
B than if both manufacture and sales are conducted in State B.

Sales through independent agents in State B

In principle, where Powerco is dealing through an independent agent, no PE is created

and no profits of Powerco are taxable in State B (Articles 7(1) and 5(6)).

© RELX (UK) Limited 2020 8 2020 Sittings

 However, there are two risks in relation to the independent agent:

 Is the agent independent both legally and economically? This is a question of

fact, principal criteria being the number of other parties represented by the agent;
the amount of time spent on the business of Powerco; and whether the agent
bears the economic risks and rewards of working on behalf of Powerco (the
updated 2017 Commentary to Article 5(6), paragraph 104). Reference should be
made to the 2017 version of Article 5(6) which clarifies this issue, and further
defines ‘independence’. This version notes that when “a person acts exclusively
or almost exclusively on behalf of one or more enterprises to which it is closely
related” then that person cannot be considered an independent agent. This can
generally be taken to mean where more than 90% of an agent’s sales are to
related parties. Enterprises are ‘closely related’ when, based on all the facts and
circumstances, one enterprise has control of the other or both are under the
control of the same person/enterprise. Confirmation should be sought as to the
status of the agents used, in particular whether they might be said to be closely
related to Powerco in any way.

 Is the agent acting in the ordinary course of his business in relation to the sale
carried out on behalf of Powerco?

This calls for an examination of the other businesses being represented by the
agent. For example, if all the agent’s other customers were wine manufacturers,
he would not be acting in the ordinary course of his business in representing a
manufacturer of power plants.

So long as the agent is genuinely independent in relation to the above tests, Powerco
would not be taxable on sales made through the agent in State B and could deduct the
sales commission from its profits in State A. Where the agent fails the test of
independence on either above criterion, the agent would still be regarded as dependent
in relation to the sales for Powerco. Powerco would thus have a dependent agent PE in
State B and be taxable there in the same way as if it had set up its own sales team.

PART 2: Tax consequences for Powerco and for the technicians of the visits to State B

For Powerco

Does Powerco have a PE in State B?

Were it not for the fact that the team is working on power plants, the answer would be
straightforward. The engineers are staying in hotels and so have no fixed place of
business (Article 5(1)), and their activities are preparatory or auxiliary to the presumed
principal profit earning activity of Powerco – the manufacture and sales of power plants
(Article 5(4)). The engineers would therefore not normally create a taxable presence for
Powerco in State B.

The possible exception to this would be to regard the business of Powerco as the
manufacture, sales and servicing of power plants. As such, after an extended presence
in State B, the power plants themselves could become a PE of Powerco (in the same
way as the painter example in 2017 Commentary on Article 5(1) para 17).

Similarly, the Commentary on Article 5 provides for the possibility of a ‘service PE’
(para 144). This again is unlikely to apply as it is principally focused on service
providing businesses. It should be recalled that this ‘service PE’ is not itself in the
Model Treaty, but can be inserted into an actual treaty as part of the negotiations of the
contracting states.

Since the core business of Powerco is likely to be found in the manufacture and sale of
power generating equipment, with the service team as merely auxiliary, no taxable
presence would be created in State B.

© RELX (UK) Limited 2020 9 2020 Sittings

 For the engineers

In principle, the engineers’ wages are taxable in State B under the provisions of Article
15(1) because they carry out work there. However, so long as the engineers do not
remain in State B for more than 183 days within any 12-month period and their
remuneration is paid by Powerco which is resident in State A, they would fall within the
exception in Article 15(2)(a)-(c) so that they are taxable solely in State A.

Tutorial Note:

This question is from a real exam paper and so the examiner has produced a very long
answer, you would not be expected to produce such detail (for example commentary
paragraph numbers) in the time allotted. However the detail in the answer is useful for
learning purposes. Credit would be given for reference to any relevant case law which
supports your arguments.

MARKING SCHEME

MARKS
Format – memorandum 2
1)
a) Subsidiary – application Art 5 – 2017 Model Art 5(5) 5
b) Factory – Art 5(1), 5(4) – 2017 Model 5
c) Sales team/warehouse – Art 5(1), 5(4), 5(5) (Agency PE, Fixed PE) –
(2017 Model) 5
d) Independent agents – Art 5(6) (2017 Model) 5
Max (Part 1) 20
2)
Powerco consequences 4
Engineer consequences 2
Max (Part 2) 5
TOTAL 25

© RELX (UK) Limited 2020 10 2020 Sittings