International Transportation and the United Nations Model Tax Convention Proposed Changes

At its recent 27th meeting in Geneva, the UN Committee of Experts discussed several items that could impact shipping specifically and, potentially, extend to international transportation generally. The Committee has requested that comments on any of its proposals be delivered to the UN Secretariat by November 10, 2023 and all proposals are available at the UN Website.

Article 8, Alternative B

This past June I was honored to be asked to address the Admiralty Committee of the Florida Bar concerning the future of shipping taxation.  Among the issues that we discussed was proposed reform of Article 8, Alternative B in the United Nations Model Convention. The global rule, predating the League of Nations and contained in the current Article 8, Alternative A and the OECD Model Income Tax Convention, is that international transportation income, shipping and aircraft, should be taxed exclusively in the country of the residence of the enterprise.

An alternative to the general rule was added to the UN Model in 1980.  It provides the ability for source States to tax shipping income, generally accomplished through what are generically called “freight taxes”.  These taxes (generally) apply the country’s statutory rate of tax to an assumed amount of gross income from domestic sources on outbound freight and passengers.  Consequently, the gross income to be taxed is stated as a flat percentage (e.g. 5%) which represents both an undefined element of domestic source income and an undefined element of assumed profit.  The effect of these taxes is, practically speaking, a tariff on exports.

This exception is contained in the UN Model as Article 8, Alternative B.  If adopted by the contracting states, it addresses source based taxes by requiring that there be an “appropriate allocation of the overall net profits” and that the tax computed accordingly be reduced by a fixed percentage to be negotiated.  Notably, alternative B is “the least adopted provision” that deviates from the OECD Model [Michel and Falcão 2021] and could be considered inconsequential.  However, the UN paper’spush for rejection of Alternative A and the OECD Model is potentially problematic when the details are examined.

The current draft changes the manner in which a source state can tax shipping (and air transport) income.  The extension of Alterative B to air transport is a significant change and has not been greeted warmly.

Under the proposal, the tax which may be imposed by the source state is the lesser of:

(a)    50 per cent of the tax otherwise imposed by the taxation law of [the source State] on the net profits from such income, or

(b)    __ percent [the percentage is to be established through bilateral negotiations] of the gross income amount of the payments underlying such income.

The proposal continues to define “income from the operation of ships or aircraft in international traffic” in a manner that differs from Article 8, Alternative A and its commentary, as well as that of the OECD, and conflicts with the statutory and case law of many jurisdictions.

One must wonder if the revised Alternative B has abandoned the concept addressing double taxation in the context of the contracting parties domestic law, and, rather, is an attempt to create taxing rights that do not presently exist.  The paper discussing the change and supporting adoption of proposed Alternative B explains little of the logic behind the changes and, rather, advocated elimination of the general rule of residence taxation for international transport.  Elimination of the general rule was the first issue on which, the Committee was polled during the meeting.

Another change to Alternative B is the reordering of the priority rules – under the general rule, interest, etc. is included as transportation income if ancillary.  Under the proposed Alternative B, income addressed in other articles of the convention can be taxed under those articles, except for article 7. If the subcommittee’s intent is to eventually extend these changes to the general rule of Alternative A, many will find this problematic.

Shipping Related to the Extractive Industries

Also relating to shipping on the United Nations’ agenda was a discussion of permanent establishments in the extractive industries sector.  The Subcommittee raised issues related to offshore installations and, specific to shipping:  “Where no adjustment to the scope of the definition of permanent establishment is made, a reference to extractives-related international shipping might be needed to grant the source state the right to tax these revenues. There may also be a need to further specify what kind of activities/ types of vessels are covered by Article 8.”

The prospect of identifying the scope of Article 8 related to offshore installations was extensively discussed in connection with the update of the 2018 version of the Handbook on Selected Issues for Taxation of the Extractives Industries.  Because the tax status of service vessels depends on the jurisdiction of coastal states, domestic tax law, vessel path and services provided (and not the type of vessel), it was decided that a general reference to Article 8 was sufficient. Also, for example, the Nordic convention addresses offshore income directly, complicating further any attempt to explain how shipping related to the offshore extractive industries is or may be taxed.

Dependent Employee Services

Finally, the Subcommittee on a multilateral convention has proposed a change to Article 15 of the Convention dealing with the compensation of employees.  Currently, both the UN and OECD model conventions place primary jurisdiction to tax wages in the jurisdiction where the worker resides.  The general rule is that, unless a worker is present in a jurisdiction (State B) more than 183 days during the year, he resides where he is tax resident (State A).  This rule applies if the employer is not a resident of, nor are the wages borne by, a permanent establishment of the employer in State B.

Another provision of Article 15 applies specifically to air and sea crew, removing the days or presence criteria and the employer residence and permanent establishment criteria.

The proposed change does not impact the allocation of taxing rights between the states where the employee resides or performs services – the 183-day rule remains intact.  Instead, it permits taxation of the employee’s earnings by the State where the employer is resident (State C) in addition to the country where the employee is resident “to the extent that the remuneration is paid by [or on behalf of] an employer resident of that other State.”

Thus, the employee may have to navigate the tax laws of his place of residence (State A), the jurisdiction in which he may be physically present for work some of the time (State B) and the treaty between these two States, if any.  That is the law today.  If the change is adopted by States B and C, the change opens the possibility that the employee will also have to navigate the tax laws of State C and the treaty, if any, between States B and C.

Consequently, the individual employee could potentially be required to file tax returns in three jurisdictions and pay taxes in two, possibly three (if State B isn’t a signatory to a convention with State A).  Interestingly, the jurisdiction gaining taxing rights may be one with which the employee has no direct contact, didn’t voluntarily enter, and from which he/she unlikely to receive any benefit.

Fortunately for shipping and aircraft personnel, the change does not apply to the provision of the article that addresses their wages.  However, discussion of this potential change has not concluded, and the issue of crew members has been discussed so the door remains open.

For those with an interest in the justification for the change, payments for non-resident labor are seen by the subcommittee as eroding the tax base of the employer’s jurisdiction of residence.

Impact on Developing Countries

Although the Article 8 and 15 proposals will increase tax revenues in developing countries, I must ask if they are counterproductive.  That is, taxing shipping and airline transport at source will increase tax revenues, primarily in developing countries.  However, this tax is the same as an excise tax on exports from these countries, increasing their price or decreasing their competitiveness in the world market.  At a minimum, both Article 8 alternatives should be retained so that they are available to countries that decide that competitiveness is more important than incremental tax revenue.

With respect to the proposed Article 15(4), where the employee will suffer a greater tax burden merely due to the State where his/her employer is resident, it appears likely that, due to the increased employee tax burden, the State C employer will have increased difficulty employing people, especially those with specific expertise not available locally.  If the employer compensates the individual for the increased State C (and State B) tax cost, it becomes less competitive than jurisdictions that do not adopt Article 15(4).