The Evolving Landscape of Double Taxation Avoidance Agreements

Introduction

The origin of the Double Taxation Avoidance Agreement (DTAA) regime dates back to 1899, when the first treaty was signed between Prussia and the Austro-Hungarian Empire. DTAAs are bilateral treaties designed to prevent the same income from being taxed twice, once in the host country where the income is generated and again in the individual’s home country. These agreements provide clarity on taxing rights, ensuring fair treatment for taxpayers while improving economic cooperation between countries. This is achieved either by limiting the taxation of income to the resident, or the source country, or by providing relief to residents from double taxation. Some key provisions of DTAAs include the setting of maximum withholding tax rates on various types of income; determining a country’s right to tax business profiles; facilitating the exchange of information between the tax authorities of the involved countries; and helping direct and prevent tax evasion while ensuring compliance with tax laws.

Models of DTAAs

DTAAs are generally based on one of two models that dictate the taxation of cross-border business activities and investments. The first is the United Nations Model Double Taxation Convention, or the UN  Model. This model offers more favorable terms for developing countries, or capital importing countries, as compared to its alternative, the OECD model, through measures such as lower thresholds for Foreign Direct Investment (FDI). Despite being the newer of the two models with its establishment in 1980, this model’s success has been limited due to various reasons such as developing countries having weak tax laws and limited negotiating capacity in the UN committee. According to various studies, the UN model has also become less relevant over time due to not being updated regularly and being more complicated to understand.

On the other hand, the OECD Model, officially known as the Organization for Economic Co-operation and Development Model Tax Convention on Income and on Capital, has become more popular over time as most bilateral tax treaties now align closely with this model. Originally designed solely for treaties between developed countries, today this model dictates treaties for both developed and developing nations, with more favorable terms for developed countries, or capital exporting countries. However, concerns have often been raised about its potential to disproportionately benefit multinational corporations headquartered in developed countries and the fact that developing countries have limited influence over the OECD Model Tax Convention because they are not OECD members.

Evolution of DTAAs

Before 2000, developing countries were increasingly signing DTAAs with developed countries, primarily to attract foreign investments and align with global tax practices. However, in recent years, there has been a notable shift, with developing countries signing an increasing number of DTAAs with other developing countries. In 2018, over half of the agreements in Africa (51%) and Asia (55%) were with non-OECD countries. And currently, out of the 2,600 DTAAs in effect worldwide, while the majority of agreements are still between developed and developing nations, approximately 500 are signed between developed economies and 800 between developing countries. This shift reflects a strategic move towards strengthening South-South trade and investment partnerships, allowing developing nations to collaborate on more balanced terms and reduce their reliance on developed economies. This diversification provides an opportunity for developing nations to negotiate tax treaties that are tailored to their economic realities, promote fairer tax regimes, and foster inclusive growth by addressing trade imbalances and facilitating smoother cross-border investments.

DTAAs’ Mixed Impact

While DTAAs have been around for a long time, their real-world impact has been widely debated. Although the agreements are said to attract FDIs, the actual evidence remains inconclusive. Some studies suggest that DTAAs can positively influence FDI by creating a more predictable tax environment for investors, making it easier for companies to establish cross-border operations. However, the effects have been found to be limited, as DTAAs may attract initial investment without significantly supporting long-term growth.

Other than concerns about its the impact on FDI, there have also been various concerns about the negative consequences of DTAAs, particularly for developing countries. Due to being based on the OECD model, the agreement often prioritizes countries where the company is based, i.e. developed countries, rather than where they operate, i.e. developing countries. Moreover, there is often an imbalance in negotiating power between the two types of countries, with developed countries having an upper hand due to greater resources and expertise. This is furthered by the lack of effective policy frameworks in many developing countries.

Emerging Challenges in Global Taxation

Along with concerns about the mixed impact of DTAAs, a growing concern in global taxation has been the misuse of the agreements, particularly through practices such as treaty shopping and Base Erosion and Profit Shifting (BEPS). These strategies, commonly employed by multinational corporations (MNCs), are designed to minimize the tax liabilities at the expense of source countries’ tax revenue.

The first practice, treaty shopping, involves entities exploiting tax treaties between two jurisdictions to benefit residents of a third country, typically by establishing a conduit company in a jurisdiction with favorable tax treaties. This practice allows companies to access treaty benefits, such as reduced withholding tax rates, without having substantial business operations in the intermediary country. For instance, a resident of State X might create a conduit company in State A while doing business in State B to derive benefits under a treaty between States A and B, even though the resident of State X is not entitled to those benefits directly. A notable example of this is the Indo-Mauritius DTAA where numerous entities routed investments through Mauritius to benefit from capital gains exemptions, leading to significant revenue losses for India. This treaty shopping arrangement was considered abusive, as the conduit companies often had no substantial economic activity in Mauritius.

On the other hand, the practice of BEPS refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations, thereby eroding the tax base of higher-tax jurisdictions. MNCs achieve this through various means, such as manipulating transfer pricing, exploiting hybrid mismatch arrangements, and leveraging preferential tax regimes. A significant real-world example of this is Apple’s tax arrangements in Ireland whereby the company shifted substantial profits to its Irish subsidiaries, benefiting from favorable tax rulings. This arrangement allowed Apple to reduce its effective tax rate significantly, leading to disputes with the European Commission. As a result of this dispute, in 2016, the European Commission even ordered Ireland to recover EUR 13 billion in unpaid taxes from Apple, stating that the arrangements violated EU state aid rules.

As the global economy becomes more interconnected and digital and the world has to increasingly face the challenges above along with obstacles related to digital taxation and cryptocurrency, renegotiating and updating DTAAs is essential. One way that countries could deal with this rising need would be for policymakers to align the agreements with international standards such as the OECD’s BEPS 2.0 framework, which is a measure to ensure that the profits are taxed where economic activities occur and to address issues like digital taxation and the allocation of taxing rights. Besides this, regular treaty reviews, engagement with stakeholders, and capacity building for developing countries are essential to ensure that tax agreements remain adaptable and inclusive. By modernizing DTAAs, countries can foster a fair, stable, and transparent tax system that supports global trade, investment, and economic growth, while ensuring that tax rights are equitably distributed across jurisdictions.

DTAA and Nepal

In terms of DTAAs in Nepal, Section 73 of the Income Tax Act, 2058 (2002) empowers the government to conclude an international agreement for the avoidance of double taxation, ensuring that taxpayers are not subjected to excessive tax burdens in both source and residence countries. So far, Nepal has signed DTAAs with 11 countries including India, Mauritius, Sri Lanka, China, South Korea, Thailand, Norway, Qatar, Austria, Pakistan, and Bangladesh. However, aside from India and China, Nepal has yet to establish DTAAs with some of its top FDI source countries, such as the United Kingdom and the United States. Currently, Nepal is negotiating treaties with the United Kingdom and Japan.

Nepal’s existing DTAAs have yielded mixed results in terms of investment inflows. For instance, investments from countries like India, China, Mauritius, and South Korea, which signed DTAAs between the late 1990s and early 2000s, have increased significantly in recent years. Conversely, FDI flows from other DTAA partner countries, such as Pakistan, Sri Lanka, Qatar, and Austria, which signed their agreements between the late 1990s and early 2000s, have remained stagnant following the signing of their treaties. Furthermore, FDI from Norway and Thailand, which signed DTAs with Nepal in the late 1990s, has declined in the years after the agreements came into effect.

To maximize the potential benefits of DTAAs, Nepal must adopt a more comprehensive approach to evaluating both existing and future agreements. This involves conducting detailed cost-benefit analyses, clearly defining treaty objectives, and aligning them with national economic policies. An evidence-based approach can help Nepal harness the full advantages of DTAA, fostering economic growth and strengthening its integration into the global economy. Moreover, as Nepal expands its DTAA network, incorporating clauses like Limitation of Benefits (LOB) provisions will be crucial to prevent treaty abuse and ensure that benefits are extended only to entities with substantial economic activity within the treaty partner country. Nepal must also adopt a more proactive approach, including regular treaty reviews and targeted reforms, to ensure these agreements align with national priorities and promote fair economic growth.

Given the fact that we live in an increasingly interconnected world, double taxation is an issue we must figure out. And as we look ahead, both for Nepal and the world, the critical questions remain: Can international tax agreements truly balance the interests of both developed and developing nations, or will they continue to favor multinational corporations at the expense of national economies? And how do we ensure DTAAs combat problems such as treaty erosion and BEPS?