Capital Gain Article - An Australian Perspective

Application of the Capital Gain Article of the MLI to CTAs – An Australia’s Perspective

- This article was published by the Tax Specialists in Australia on 16 Feb 2023 - [read]

 

Article 9(1) of the MLI is a provision to counteract tax avoidance. Paragraph 1 specifically addresses situations in which non-real property assets are contributed to a land-rich entity shortly before the sale of shares or comparable interests (such as interests in a partnership or trust) in that entity in order to dilute the proportion of the value of the entity that is derived from immovable property. Article 9(1) and Article 9(2) read:

 

“(1) Provisions of a Covered Tax Agreement providing that gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or other rights of participation in an entity may be taxed in the other Contracting Jurisdiction provided that these shares derived more than a certain part of their value from immovable property (real property) situated in that other Contracting Jurisdiction (or provided that more than a certain part of the property of the entity consists of such immovable property (real property)):

a) shall apply if the relevant value threshold is met at any time during the 365 days preceding the alienation; and

b) shall apply to shares or comparable interests, such as interests in a partnership or trust (to the extent that such shares or interests are not already covered) in addition to any shares or rights already covered by the provisions.”

 

“(2) The period provided in subparagraph a) of paragraph 1 shall apply in place of or in the absence of a time period for determining whether the relevant value threshold in provisions of a Covered Tax Agreement described in paragraph 1 was met.”

 

Article 9(1) of the MLI is designed to achieve the same purpose as article 13(4) of the OECD Model Tax Convention (the MTC) does. In accordance with the recommendation in paragraph 129 of the Action 6 Final Report, the 2017 version of the MTC provides two changes with respect to Article 13(4) of the 2014 version: (i) to introduce a testing period for determining whether the condition on the value threshold is met; and (ii) to expand the scope of interests covered by that paragraph to include interests comparable to shares, such as interests in a partnership or trust. The provision in paragraph 1 of article 9 has been divided into two subparagraphs. Subparagraph a) reflects the introduction of the testing period, and subparagraph b) reflects the expansion of the interests covered.

 

Article 9(1) is both a substantive provision that deals with tax avoidance and a compatibility (or conflict) provision that modifies the provision of a covered tax agreement (CTA), using a specified wording “shall apply to”. In contrast, article 9(2) is a compatibility provision that modifies the application of article 9(1) to the CTA, using a specified wording “shall apply in place of or in the absence of”.

 

Notification to the OECD Depositary

 

Australia notified the OECD Depositary under article 9(7) that paragraph 1 of article 9 shall apply in place of the previously existing provision in — or, in the absence of such a provision be added to — all its 42 CTAs, including the tax treaties with China, India, Japan, New Zealand, Singapore, and other countries in the Indo-pacific region.

 

The tax treaties notified as per art 2(1)(a) of the MLI can be divided into three categories:

1. the treaty partner not yet signing the MLI;
2. the treaty partner having signed the MLI but not including Australia in its list of tax treaties that it wishes to be covered under art 2(1)(a) of the MLI; and
3. the treaty partner has signed the MLI and also included Australia in its tax treaty list under article 2(1)(a) of the MLI.

 

Table 1 - Overview of Australia’s MLI position

 

Category		Status	Total
1.	Bilateral tax agreements with parties who have not signed the MLI	The non-MLI bilateral agreements include Kiribati, the Philippines, Sri Lanka, the United States	4
2.	Bilateral tax agreements not included in CTA list by both parties	Jurisdictions include Austria, Sweden, and Switzerland	3
3.	Bilateral tax agreements included in the CTA list by both parties	A total of 11 CTAs is modified by the MLI provision subject to the reservations made (among them, 9 of the parties to the Australia’s CTAs have made a full reservation. 2 parties have made a partial reservation). The remaining 24 CTAs are modified by the compatibility provisions under article 9(2), or article 9(5) if they choose article 9(4), the alternative provision to article 9(1).	35
	Total tax treaties notified		42

 

The 4 jurisdictions under category 1 in table I are not MLI signatories. As per the action 6 final report, signing up to the MLI is not mandatory to implement the BEPS measures to the tax treaties. The four (4) jurisdictions that have not signed up the MLI could start bilateral renegotiation with Australia to bring the tax treaties in line with the BEPS recommendation on the avoidance of capital gain tax. [1]

 

Under category 2, three treaty partners have not included Australia in the CTA list. The number of CTAs to be modified by the MLI provision would be increased by 3 to 38 if Austria, Sweden, and Switzerland include Australia to their lists of CTAs later in accordance with article 29(5).

 

As indicated under category 3 in table 1, nine (9) contracting jurisdictions have made a full reservation in accordance with article 9(6)(a) for article 9(1) not to apply to the CTAs concluded with Australia, including Finland, Hungary, Korea, Malaysia, Norway, Romania, Singapore, Thailand, United Kingdom. Two (2) contracting jurisdictions Belgium and China have reserved the right under article 9(6)(b) for the 365-day period not to apply to the CTAs with Australia.

 

In what follows, the article will compare the MLI position of Australia with some of her treaty partners and will examine the interaction between the positions of the selected parties and the synthesized texts resulting from such interactions.

 

Interaction between the Operative Provision and the Compatibility provision

 

Table 2 - Comparing Australia’s MLI position with that of selected countries or jurisdictions [2]

 

	Apply article 9(1) to the CTA?	Reserve for article 9(1) not to apply to CTA?	Exclude 365-day test under article 9(1)(a) from CTA?	Exclude comparable interest under art. 9(1)(b)	Choose to apply article 9(4) to CTA?
	Main provision	Full reservation	Partial reservation	Partial reservation	Alternative provision
Australia	Yes			Yes, per art. 9(6)(e)
China	Yes		Yes, per art. 9(6)(b)
India, Japan, New Zealand	Yes				Yes, per art. 9(3)
Korea, Malaysia, Singapore	No	Yes, per art. 9(6)(a)

 

Interaction between the operative provision and the compatibility provision

 

The compatibility provision under article 9(2) (or article 9(5)) modifies in specified languages the application of article 9(1) (or article 9(4)) of the MLI to the CTA provision, subject to the reservations made. Paragraph 6 of article 9 - reservation provides that

 

“6. A Party may reserve the right:

1. for paragraph 1 not to apply to its Covered Tax Agreements;
2. for subparagraph a) of paragraph 1 not to apply to its Covered Tax Agreements;
3. for subparagraph b) of paragraph 1 not to apply to its Covered Tax Agreements;
4. for subparagraph a) of paragraph 1 not to apply to its Covered Tax Agreements that already contain a provision of the type described in paragraph 1 that includes a period for determining whether the relevant value threshold was met;
5. for subparagraph b) of paragraph 1 not to apply to its Covered Tax Agreements that already contain a provision of the type described in paragraph 1 that applies to the alienation of interests other than shares;
6. for paragraph 4 not to apply to its Covered Tax Agreements that already contain the provisions described in paragraph 5.”

 

The capital gains article in the CTAs that Australia concluded with Korea, Malaysia, and Singapore will be excluded from modification by article 9(1) of the MLI because each of the tax treaty partner has reserved its right under 9(6)(a) for the entire article 9(1) to not apply to all its CTAs, without making the choice to apply the alternative provision under article 9(4).

 

Illustrated Example – Reservation under article 28(3)

 

As per Table 2, China deposited its Instrument of ratification on 25 May 2022, the Australia-China CTA will come into force on 1^st Sept 2022 in accordance with article 34(2) of the MLI. As China reserves its right for 365-day test under article 9(1)(a) not to apply to all its CTAs in accordance with article 9(6)(b), the modified text of article 13(4) of the Australia-China CTA will be modified in accordance with article 9(2) of the MLI subject to reservation made under article 9(6)(b) as follows: -

 

The following subparagraph b) of paragraph 1 of Article 9 of the MLI applies to paragraph 4 of Article 13 of this Agreement: [3]   ARTICLE 9 OF THE MLI CAPITAL GAINS FROM ALIENATION OF SHARES OR INTERESTS OF ENTITIES DERIVING THEIR VALUE PRINCIPALLY FROM IMMOVABLE PROPERTY   Paragraph 4 of Article 13 of the Agreement [the Australia-China CTA] shall apply to shares or comparable interests, such as interests in a partnership or trust (to the extent that such shares or interests are not already covered) in addition to any shares or rights already covered by the provisions of this Agreement.

 

MLI’s Reservation and notification mechanisms

 

Each article of the MLI including article 9 is designed to address a specific BEPS issue. Where a contracting party chooses to adopt or not to adopt an article (or the provision of an article), it may do so by using the reservation and the notification mechanism of the MLI, as set out in table 3:

 

Table 3 – Reservation and notification rules of the MLI

A party choosing to adopt an article, or the provision of an article may
give notification for the adoption of the article (or the provision of an article), or	Article 9(7): a party gives notification to adopt the alternative provision (9(4))
make no reservation for the application of the article (or provision of an article) to the CTAs.	A party who has not reserved its right for article 9(1) not to apply need not do anything.
A party not choosing to adopt an article, or the provision of an article may
do so by not giving notification for the adoption of the article (or provision of an article), or	A party can do nothing for article 9(3) that provides that a party may adopt the alternative provision of article 9(4).
reserve its right for the article (or provision of an article) not to apply to the CTAs [see note below]	Article 9(6)(a): a party reserves its right for article 9(1) not to apply. Article 9(6)(b): a party reserves its right for the 365-day test (article 9(1)(a)) not to apply. Article 9(6)(c): a party reserves its right for comparable interest (article 9(1)(b)) not to apply.

 

As noted above, the reservation made in accordance with the article 28(3) imposes restriction in whole or in part on the application of the MLI provision to the CTA. Article 28(3) reads: -

 

“3. Unless explicitly provided otherwise in the relevant provisions of this Convention, a reservation made in accordance with paragraph 1 or 2 shall:

a) modify for the reserving Party in its relations with another Party the provisions of this Convention to which the reservation relates to the extent of the reservation; and

b) modify those provisions to the same extent for the other Party in its relations with the reserving Party.”

 

Article 28(3) contains two principles regarding reservations. First, unless explicitly provided otherwise, a reservation made on a unilateral basis will not only have an effect on the CTA between the reserving party and the other contracting party, but also have an effect on all other CTAs that a contracting party has nominated in accordance with paragraph (1)(a) of article 2 (interpretation of terms) and paragraph 5 of article 29 (notifications) of the MLI. The main exception to this rule is that a reservation to apply the arbitration articles under Part VI of the convention require acceptance under article 28, paragraph 2 of the MLI. Second, unless explicitly provided otherwise, a reservation for an article (or a provision of an article) is reciprocal in application. That is, a reservation made under article 28(3) does not work only one way. In general, a reservation shall apply symmetrically to both parties to the MLI.

 

Replacement or withdrawal of reservation

 

As per table 2, article 9(1) would apply to the Australia-Singapore CTA (the Australia-Korea or the Australia-Malaysia CTA) if Singapore (Korea or Malaysia) later chose to withdraw its article 9(6)(a) reservation as permitted under article 28(9) of the MLI. Similarly, article 9(1)(a) of the MLI would apply to the Australia-China CTA if China later chose to withdraw its article 9(6)(b) reservation.

 

Note that Australia is not permitted to make additional reservation under article 9(6)(a) to bring its MLI position in line with Singapore. Nor can Australia make additional reservation pursuant to article 9(6)(b) to bring its MLI position in line with China.

 

In contrast, Singapore is permitted to replace its article 9(6)(a) reservation with the article 9(6)(b) reservation, which is more limited in scope.

 

Article 28 of the MLI only works in one direction for making changes to the scope of the reservation. The reason is that when a party withdraws a reservation or replaces it with one that is more limited in scope, it will be moving closer to the full adoption of the MLI — not away from it.

 

Illustrated examples – Reservation under article 28(8) (the Later-in-time rule)

 

Australia considers that under article 9(7), the following agreements contain a provision described in article 9(1). The article and paragraph number of each is listed in Table 4A.

 

List of Covered Tax Agreements

 

Table 4A – Australia’ MLI position as notified to the OECD Depositary on the day of Ratification of Instrument {Extracts} [4]

 

Listed agreement number	Contracting jurisdictions	Provisions in the CTAs
6	China *	Article 13(4)
13	India *	Article 13(4)
17	Japan	Article 13(2)
19	Korea	Article 13(1), 13(2)(a)(iii) and (b)(iii)
20	Malaysia *	Article 13(4) of agreement 20 after the amendment by article 6 of its amending instrument (a)
24	New Zealand	Article 13(4)
31	Singapore *	Article 10A(4) of Agreement 31 after the amendment by Article 12 of its amending instrument (a)

[*] the MLI contracting jurisdictions that are not the OECD members are members of the Inclusive Framework on BEPS. [5]

 

Reservation under article 28(8)

 

Pursuant to Article 9(6)(e) of the Convention, Australia reserves the right for Article 9(1)(b) not to apply to its Covered Tax Agreements that already contain a provision of the type described in Article 9(1) that applies to the alienation of interests other than shares.

 

Table 4B - The CTAs that contain provisions falling within the scope of the 9(6)(e) reservation

 

Listed agreement number	Contracting jurisdictions	Provisions in the CTAs
17	Japan	Article 13(2)
24	New Zealand	Article 13(4)

 

Application of article 9(1) subject to the later-in-time rule

 

Australia reserves its right for article 9(1)(b) not to apply to its some of its CTAs in accordance with article 9(6)(e). Australia does it because the “share or comparable interest” provision has already been included in the CTAs that it has concluded with some of the parties to the MLI, including Japan, Malaysia, and New Zealand (see Table 4B). Paragraph 2 of article 13 (alienation of property) in the Australia-Japan CTA is compatible with article 9(1)(b) of the MLI. Put differently, article 13(2) is a compliant provision, to which the later-in-time rule in article 30(3) of the Vienna Convention on the Law of Treaties applies. Article 30(3) of the VCLT provides that: -

 

“3) When all the parties to the earlier treaty are parties also to the later treaty but the earlier treaty is not terminated or suspended in operation under article 59 [of the Convention], the earlier treaty applies only to the extent that its provisions are compatible with those of the later treaty.” [6]

 

Australia has not reserved its right for article 9(1)(a) not to apply under article 9(6)(d). Therefore, article 9(1)(a) will apply in the absence of a time period for determining whether the relevant value threshold in the provision of the Australia-Japan CTA described in article 9(1) is met, in accordance with article 9(2) of the MLI. The modified text of article 13(2) in the Australia-Japan CTA will be as follows:

 

“Income, profits, or gains derived by a resident of a Contracting State from the alienation of shares in a company or of interests in a partnership, trust or other entity may be taxed in the other Contracting State where the shares or the interests derive at least 50 per cent of their value directly or indirectly from real property referred to in Article 6 and situated in that other Contracting State. Paragraph (1)(a) of Article 9 of the Convention [the MLI] shall apply if the relevant value threshold is met at any time during the 365 days preceding the alienation.” [Emphasis added.]

 

New Zealand is also on the list of the article 9(6)(e) reservation. The modification to the Australia-New Zealand CTA follows the same legal logic and language pattern as the Australia-Japan CTA.

 

Concluding comment

 

There is a distinction between reservations made under article 28(3) and under article 28(8). On the one hand, the reservation made under article 28(3) is a full reservation that provides that an article of the MLI, such as article 9(6)(a), or the provision of an article of the MLI, such as article 9(6)(b) and 9(6)(c), shall not only apply to the CTA that a party to the MLI has concluded, but also to all other CTAs that the reserving party has nominated in the CTA list. The article 28(3) reservation owes its legal basis to article 21(1) of the Vienna Convention on the Law of Treaties. On the other hand, the reservation made in accordance with article 28(8) is a partial reservation that only applies to some but not all the CTAs, such as the reservation under article 9(6)(d), article 9(6)(e), and article 9(6)(f). The article 28(8) reservation owes its legal basis to article 30(3) of the Vienna Convention on the Law of Treaties. Where a party has made reservation for the provisions of the MLI not to apply to a CTA in accordance with paragraph 8 of article 28, that CTA is a compliant agreement for which that party is not obligated to do anything. A party is obligated to modify its CTA that is not a compliant agreement upon request by a treaty partner that has made the same commitment under the OECD/G20 inclusive framework on BEPS, subject to reservations made in accordance with article 28(3).

 

Alfred Chan (Dr.)

China Tax & Investment Consultants Ltd

www.china-tax.net