MLI - Capital Gain Article

New Interpretation of the Capital Gain Article in the OECD Multilateral Instrument

[This article was published in Tax Notes International on 29th Nov 2021.] ->download

 

On 3 May 2021, the Conference of the Parties (the COP) to the Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent Base Erosion and Profit Shifting (the MLI) issued an opinion, titled “Interpretation and Implementation Questions”. The opinion (May-3 opinion) was issued to address the questions that had arisen in the interpretation and application of the MLI after the conclusion of the MLI on 7 June 2017.

 

This article provides an in-depth analysis of the Capital Gain article of the MLI, in the light of the information in the opinion of the COP. It starts with the exception that the COP identified in its May-3 opinion regarding the interaction between the notification clause and the compatibility clause, which is also the focus of this analysis. By examining the language pattern used in the compatibility and the notification clauses, the author derives the general conception from the specifics, and then applies those concepts to the cases that illustrate how the MLI provisions modify the covered tax agreements concluded by some selected countries in the Asia-Pacific region.

 

[I] Conference of the Parties

 

The COP categorized its May-3 opinion into six guiding principles, which provide the theoretical and technical tools in the interpretation and implementation of the MLI.

 

The third guiding principle introduces the later in time rule. It states that the application of the MLI to the CTAs follows the general principle that when two rules apply to the same subject matter, the later in time rule prevails (lex posterior derogate legi priori), that to the extent that they are incompatible.

 

The COP to the MLI in its May-3 opinion endorses the term “MLI positions” under principle 4 that was first used by in the Note by the OECD Directorate for Legal Affairs. [1] It provides that the MLI should be interpreted in the light of the consent given by each Contracting Jurisdiction to modify their Covered Tax Agreement, as expressed in their MLI Positions and with the consequences set out in the relevant provisions of the MLI. The MLI, while respecting the sovereign autonomy of the countries and the bilateral nature of the CTAs, allows for different forms of flexibility through a system of reservations, and notifications of choices of alternative provisions and optional provisions. The lists of Covered Tax Agreements, reservations and notifications are submitted in the form of so-called “MLI Positions” which represent the boundaries of each Party’s consent to modify its Agreements.

 

The opinion in Guiding Principle 5 provides that the compatibility clauses set out whether, and to what extent, provisions in the MLI interact with existing provisions of Covered Tax Agreements. When a substantive MLI provision conflicts with specific existing provisions in Covered Tax Agreements covering the same subject matter, this conflict is addressed through a description in the compatibility clause of the existing provisions which the MLI is intended to modify, as well as the effect the MLI has on those existing provisions.

 

Guiding Principle 6 provides that the notification clauses ensure clarity and transparency about the existing provisions of Covered Tax Agreements that are modified by the MLI. While the notifications sometimes trigger the application of the MLI, it does not apply in some other cases.

 

[II] The application of the MLI to CTAs

 

As explained by the May-3 Opinion, the compatibility clause that is the cornerstone for the implementation of the MLI, objectively defines the relationship of the provisions of the MLI with the provisions of the CTAs, in respect of its interactive relationships with the operative clauses and the notification clauses respectively.

 

Mechanisms on the application of the MLI to CTAs

 

The MLI modifies the application of CTAs in four different ways using specified languages. Specifically, the MLI provision

• “Applies in place of" an existing provision (case a),
• “Applies to" or "modifies" an existing provision (case b),
• “Applies in the absence of" an existing provision (case c), or
• “Applies in place of or in the absence of" an existing provision (case d).

 

The operation of the MLI provision requires the notification by both contracting jurisdictions (parties) to the CTA of the existence (cases a and b) or the absence (case c) of an existing provision. In respect of case d, the MLI provision will apply in all cases [Emphasis added], regardless of whether the notification has been given by the parties.

 

Notification clauses can serve two purposes in the operation of the MLI. First, when an MLI provision modifies specific types of existing provisions described in compatibility clauses, parties to the MLI are generally required to make a notification to identify which existing provisions of CTAs are within the scope of compatibility clauses. Second, notifications made under the MLI sometimes have the effect of triggering the application of the MLI.

 

The May-3 Opinion states that there are exceptions in the notification mechanism to achieve the purposes mentioned in the preceding paragraph. In respect of the first purpose, the parties to a CTA are also required to notify a list of CTAs that do not contain a provision described in a compatibility clause. Take Article 6(3) for example, which provides that:

A party may also choose to include the following preamble text with respect to its Covered Tax Agreements that do not contain preamble language referring to a desire to develop an economic relationship or to enhance co-operation in tax matters: “Desiring to further develop their economic relationship and to enhance their co-operation in tax matters,”.

 

The quoted sentence is added to the preamble language paragraph if does not exist in the CTA. In respect of the second purpose, a Party is obligated to give notification in order that the compatibility clause should take effect. The CoP also opinioned that:

“Article 8 of the MLI (Dividend Transfer Transactions), which contains a compatibility clause in its article 8(2) referring to “in place of or in the absence of”, does not operate in the same manner. Rather, Article 8(2) of the MLI describes the interaction between its article 8(1) and existing provisions of Covered Tax Agreements only with respect to minimum holding periods. In this case, notifications made under Article 8(4) of the MLI have the effect of triggering the application of Article 8(1) of the MLI. This is also true for Article 9(2) of the MLI, which cannot apply without an existing provision described in Article 9(1) of the MLI.” [2]

 

A summary of the notification rule for the purpose of giving legal effect to the operative clause is set out in table 1 below:

 

Table 1 - Summary of different use of the notification rules

Specified phrases for cases a) to d)	Notification required to take legal effect?	Notes
a) applies in place of	Yes
b) applies to or modifies	Yes
c) applies in the absence of	Yes	It is also used to notify a list of CTAs that do not contain the provision described in the compatibility clause
d) applies in place of or in the absence of	No, the compatibility clause shall apply in all cases regardless of whether notification is given.	Except for paragraph 4 of Article 8 (dividend transfer transactions), and paragraph 7 of Article 9 (Capital Gain)

 

To facilitate further analysis, the legal texts of Article 9 (Capital Gains from Alienation of Shares or Interests of Entities Deriving their Value Principally from Immovable Property) is reproduced below: -

 

Table 2 – full texts of Article 9

Main provisions	Alternative Provisions
	3. A Party may also choose to apply paragraph 4 with respect to its Covered Tax Agreements.
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 or rights 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.	4. For purposes of a Covered Tax Agreement, gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or comparable interests, such as interests in a partnership or trust, may be taxed in the other Contracting Jurisdiction if, at any time during the 365 days preceding the alienation, these shares or comparable interests derived more than 50 per cent of their value directly or indirectly from immovable property (real property) situated in that other Contracting Jurisdiction.
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.	5. Paragraph 4 shall apply in place of or in the absence of 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 or rights 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).
6. A Party may reserve the right:
a) for paragraph 1 not to apply to its Covered Tax Agreements; b) for subparagraph a) of paragraph 1 not to apply to its Covered Tax Agreements; c) for subparagraph b) of paragraph 1 not to apply to its Covered Tax Agreements; d) 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; e) 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;	f) for paragraph 4 not to apply to its Covered Tax Agreements that already contain the provisions described in paragraph 5.
7. Each Party that has not made the reservation described in subparagraph a) of paragraph 6 shall notify the Depositary of whether each of its Covered Tax Agreements contains a provision described in paragraph 1, and if so, the article and paragraph number of each such provision. Paragraph 1 shall apply with respect to a provision of a Covered Tax Agreement only where all Contracting Jurisdictions have made a notification with respect to that provision.	8. Each Party that chooses to apply paragraph 4 shall notify the Depositary of its choice. Paragraph 4 shall apply to a Covered Tax Agreement only where all Contracting Jurisdictions have made such a notification. In such case, paragraph 1 shall not apply with respect to that Covered Tax Agreement. In the case of a Party that has not made the reservation described in subparagraph f) of paragraph 6 and has made the reservation described in subparagraph a) of paragraph 6, such notification shall also include the list of its Covered Tax Agreements which contain a provision described in paragraph 5, as well as the article and paragraph number of each such provision. Where all Contracting Jurisdictions have made a notification with respect to a provision of a Covered Tax Agreement under this paragraph or paragraph 7, that provision shall be replaced by the provisions of paragraph 4. In other cases, paragraph 4 shall supersede the provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with paragraph 4.

 

Comparing the Main Article and the Alternative Article

 

Article 9(1) prescribes two requirements to be met for the taxation on capital gain arising from disposal of shares in a land-rich entity: first, a time period test to determine whether gains from the disposal of shares or comparable interests in an entity deriving most part of the values from landed properties situated in the other contracting jurisdiction is taxable; second, the inclusion of comparable interests to the scope of shares that are the subject of article 9(1). Article 9(4) is an alternative provision which provides both the time period test and the value threshold test for shares in an entity holding immovable property or comparable interests, in respect of which a party to the MLI may choose to the exclusion of Article 9(1). These two articles are for the parties to choose to achieve the same policy objective under the BEPS measures in Action 6.

 

The compatibility clause of articles 9(2) and 9(5) respectively modify article 9(1)(a) and article 9(4) using the same language “shall apply in place of or in the absence of” the relevant provisions, as referred to in case (d) above. It is noted that the language of notification given under article 9(7) and article 9(8) are the same. But the reasons why the notifications are given are different, as is set out in what follows.

 

The modification of Article 9(1) by Article 9(2) will not take effect until both parties give notification under Article 9(7). The notification clause reads: “Paragraph 1 shall apply with respect to a provision of a Covered Tax Agreement only where all Contracting Jurisdictions have made a notification with respect to that provision.” Note that the use of the preceding sentence in Article 9(7) is to trigger the application of the modification by article 9(2) to article 9(1). That is an exception to the cases of other MLI articles that provides that where the provision of the MLI “apply in place of or in the absence of” is used to modify the operative clause, the compatibility clause shall apply in all cases irrespective of whether notification is required. [Emphasis added.]

 

The modification of Article 9(4) by Article 9(5) will apply subject to matching notifications being given. Article 9(8) reads: “Paragraph 4 shall apply to a Covered Tax Agreement only where all Contracting Jurisdictions have made such a notification. In such case, paragraph 1 shall not apply with respect to that Covered Tax Agreement”. The notification is required to inform all other parties to the MLI that the notifying party has chosen to adopt (or opted in for) article 9(4), the alternative provision to Article 9(1), in accordance with Article 9(3). It is also used to clarify that articles 9(1) and 9(4) are mutually exclusive in application.

 

Definition of Covered Tax Agreement

 

Furthermore, a standard wording has been used in Article 9(8), which reads:

"Where all Contracting Jurisdictions have made a notification with respect to a provision of a Covered Tax Agreement under this paragraph or paragraph 7, that provision shall be replaced by the provisions of paragraph 4. In other cases, paragraph 4 shall supersede the provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with paragraph 4.”

The purpose of the languages used in paragraph 9(8) is not for triggering the application of Article 9(4). Rather it serves the purpose of enhancing clarity and transparency in the implementation of the MLI. In a bilateral CTA, "all parties" means both parties, and vice versa. If both parties give a matching notification, the MLI provisions shall apply to the CTA provision. In a multilateral CTA that consists of at least three bilateral relationships, the MLI provision will apply to the multilateral CTA only if both parties in every bilateral relation have given matching notifications. [3] Where the parties in one of the bilateral relations have not given a matching notification, the MLI provision will not apply to the corresponding provision in the multilateral CTA. In case that the matching and non-matching notifications co-exist in a multilateral CTA, paragraph 4 shall “supersede the provisions of the CTA only to the extent that those provisions are incompatibility with paragraph 4”.

 

It is useful to examine paragraph 1 of Article 2 (Interpretation) that provides that:

"a) The term“Covered Tax Agreement” means an agreement for the avoidance of double taxation with respect to taxes on income (whether or not other taxes are also covered):

i) that is in force between two or more:

A) Parties; …

ii) with respect to which each such Party has made a notification to the Depositary listing the agreement as well as any amending or accompanying instruments thereto ... as an agreement which it wishes to be covered by this Convention.”

 

It is useful to make a comparison between the compatibility clause of the arbitration Article, adopted by two parties under Article 18 under Part VI, and the compatibility clause, used by the parties in article 9 of the MLI (and the other articles of the MLI). the notification clause in the arbitration articles and article 9 are worded differently, as shown below: 

 

Table 3 – comparing Article 9 with Article 26

Article 9 – Capital gain from Alienation of Shares or Interests of Entities Deriving their Value Principally from Immovable Property	Article 26 – Compatibility under Part VI - Arbitration
5. Paragraph 4 shall apply in place of or in the absence of 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 or rights 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).	1. Subject to Article 18 (Choice to Apply Part VI), the provisions of this Part shall apply in place of or in the absence of provisions of a Covered Tax Agreement that provide for arbitration of unresolved issues arising from a mutual agreement procedure case. Each Party that chooses to apply this Part shall notify the Depositary of whether each of its Covered Tax Agreements, other than those that are within the scope of a reservation under paragraph 4, contains such a provision, and if so, the article and paragraph number of each such provision. Where two Contracting Jurisdictions have made a notification with respect to a provision of a Covered Tax Agreement, that provision shall be replaced by the provisions of this Part as between those Contracting Jurisdictions.
8. …  Where all Contracting Jurisdictions have made a notification with respect to a provision of a Covered Tax Agreement under this paragraph …, that provision shall be replaced by the provisions of paragraph 4. In other cases, paragraph 4 shall supersede the provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with paragraph 4.

 

The knowledge of the standard wording for the notification used in connection with the term “covered tax agreement” is useful for us to understand the same contents in the rest of the MLI in that the same language is used in a total of ten articles, including Article 9, that are contained in Part II (Hybrid Mismatches), Part III (Treaty Abuse), Part IV (Avoidance of Permanent Establishment Status), and Part V (Improving Dispute Resolution) of the MLI.

 

The “Later in Time” Rule

 

The May-3 Opinion issued by the Conference of the Parties explicitly provided that “the later in time rule” in Guiding Principle 5 shall apply in the interpretation of the MLI. The rule provides that the approach taken in the MLI follows the general legal principle that when two rules apply to the same subject matter, the rule that is later in time prevails (lex posterior derogat legi priori).

 

Article 9(6) provides for six reservations, five being applicable to Article 9(1) and one being applicable to Article 9(4), in respect of which a party is permitted to make in accordance with paragraph (1)(g) of Article 28 – Reservation. The reservation clauses in Article 9(6) reads:

 

“A Party may reserve the right:

(a) for paragraph 1 not to apply (to opt out of) to its CTAs;

(b) for paragraph (1)(a) not to apply to its CTAs;

(c) for paragraph (1)(b) not to apply to tis CTAs;

(d) for paragraph (1)(a) not to apply to the CTAs 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;

(e) for paragraph (1)(b) not to apply to the CTAs that already contain a provision of the type described in paragraph 1 that applies to the alienation of interests other than shares;

(f) for paragraph 4 not to apply to its CTAs that already contain the provisions described in paragraph 5.”

 

Because Article 9 does not come within the scope of the minimum standards in the BEPS package, Article 9(6)(a) is a full reservation (exclusion) that a party can adopt. If a party does so, the whole of the capital gain article shall not apply unless the same party opts in for the alternative provision under article 9(4). In contrast, articles 9(6)(b) to (f) are all partial reservations, which fall into different categories under two important principles of public international law. On the one hand, Articles 9(6)(b) and (6)(c) are partial reservations that restrict the scope of the application of the MLI provision to the corresponding provisions of all, instead of some, of the CTA, in accordance with the provision of paragraph 3 of Article 28 (Reservations) of the MLI, which replicates Article 21(1) of the Vienna Convention of the Law of Treaties (the VCLT). On the other hand, Articles 9(6)(d), (6)(e) and (6)(f) are partial reservations that only apply to some of, instead of all, the CTAs, and that appears at odds with the reciprocity principle in public international laws, in respect of which Article 28 has not explicitly dealt with.

 

A contracting jurisdiction is permitted to make such reservations under article 9(6)(d), (6)(e), or (6)(f) because the relevant CTA provisions are modelled on Article 13(4) of the OECD Model Convention (2017), as revised in paragraph 44 (page 72) of the BEPS Action 6 Final Report. In other words, because the provision of the CTA is compatible, or not in conflict, with article 9(1)(a) or 9(1)(b) of the MLI, it is excluded from the modification by the compatibility clause under Article 9(2). The exclusion to the reciprocity principle owes its legal basis to article 30(3) of the VCLT that provides that:

 

“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 (the Vienna Convention), the earlier treaty applies only to the extent that its provisions are compatible with those of the later treaty.”

 

This means that where an existing CTA (the earlier treaty) contains a provision that addresses the same issue as that under the relevant MLI article, that CTA provision should be excluded from (opted out of) the modification by the compatibility clause and shall continue to apply in future. As noted, this is endorsed by the COP in its May-3 Opinion.

 

[III] Implementation of MLI at country levels

 

The information in the table below is extracts from the database kept by the OECD Depositary as of 14^th December 2021 that contains the MLI position of the Signatories and Parties to the MLI [4] and the Matrix of options and reservations. [5] The crosses [x] in the boxes of the table represent the reservations that the Parties have made in accordance with Article 28 of the MLI, and the notification given for choosing an optional or alternative provision in accordance with Article 29 of the MLI.

 

Table 4 – the MLI position of selected countries

Selected parties	Article 9(1) main provision	Article 9(1) main provision	Article 9(4) alternative provision	Remarks
	9(6)(a), reserve for 9(1) not to apply	9(6)(e), reserve for 9(1)(b) not to apply	9(8), notify to opt-in for 9(4)
Australia		X		^ later in time rule applies
Japan			X	# Matching notification is given
India			X	# Matching notification is given
New Zealand			X	# Matching notification is given
Singapore	X			@ Opt out of entire Article 9(1)

 

Australia-Japan CTA

 

The following are the extracts of the reservation made and notification given by Australia (the MLI position). [6]

 

In accordance with article 9(6)(e), Australia reserves the right not to apply article 9(1)(b) to CTAs that already contain a provision described in article 9(1) applying to the sale of interests other than shares. The double tax agreements listed in Table 5 are within the scope of this reservation.

 

Table 5 – Extracts of Australia’s notification of reservation

 

Listed agreement number	Contracting jurisdictions	Provision
17	Japan	Article 13(2)
24	New Zealand	Article 13(4)

 

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 6.

 

Table 6 – Extracts of Notification of Australia’s CTAs as Modified by Article 9(1)(a)

 

Listed Agreement Number	Contracting Jurisdictions	Provision
13	India	Article 13(4)
17	Japan	Article 13(2)
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)

 

Australia reserves its right for article 9(1)(b) not to apply to its CTAs concluded with Japan, in accordance with the notification given in its MLI position. Australia makes the reservation because the “share or comparable interest” provision has been included in the CTAs that Australia concluded with some of the parties to the MLI, including Japan. In other words, Article 9(1)(b) here is compatible with the corresponding provision (paragraph 2 of Article 13 (Alienation of Property)) in the Australia-Japan CTA, as per the “later in time” rule.

 

In the absence of a reservation made under paragraph (6)(d) of Article 9, Article 13(2) of the Australia-Japan CTA is modified by the 365-day holding period provision under paragraph 1(a) of Article 9 of the MLI. Consequently, the modified texts will contain the same contents as Article 9(4), which reads: -

 

“2. 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 2 of Article 13 of the Convention [the Australia-Japan CTA] shall apply if the relevant value threshold is met at any time during the 365 days preceding the alienation.

 

Australia-India CTA

 

Australia and India have given notifications that provide that article 9(1) and article 9(4) apply in accordance with article 9(7) and 9(8). The modification to the Australian-India CTA follows the same legal logic and language pattern as that for Australian-Japan CTA.

 

Japan-India CTA, Japan-NZ CTA, and India-NZ CTAs

 

Paragraph 4 of Article 9 of the MLI shall replace paragraph 2 of Article 13 of the Japan-India CTA, the Japan-NZ CTA, and the India-NZ CTAs because the all the parties have opted in for Article 9(4) and given a matching notification in accordance with article 9(8) for each of the three bilateral relationships.

 

Australia-Singapore CTAs

 

There is no capital gain tax in Singapore. The capital gain article in the CTAs concluded by Singapore with Australia, will be excluded from modification by Article 9 of the MLI because Singapore has reserved its right for article 9(1) not to apply to all its CTAs, in the absence of making the choice to apply Article 9(4). However, article 9(1) would apply to the Australia-Singapore CTA if Singapore later chose to withdraw its article 9(1) reservation as permitted by article 28(9) of the MLI. Note that Australia is not permitted to make additional reservations to bring its MLI position in line with Singapore. 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.

 

[IV] Conclusion

 

The Opinion issued by the COP on 3 May 2021 helps clarify the doubts and overcome the difficulties arising as to the interpretation and implementation of the reservation and notification provisions in the MLI. It is believed that the anatomy of the capital gain article - a single article of the MLI - serves the purpose that the knowledge acquired from the capital gain article can guide us to understand the logic structures in other parts of the MLI, including the notification rules used in connection with the compatibility clause, and the later in time rule used in connection with the reservation clause.

 

Authored by Alfred Chan, China Tax & Investment Consultants Ltd