Service fees - credit of foreign tax problems with Brazil, China and India

WebJournal on International Taxation in Sweden, WITS no 1/2014
by Peter Sundgren

Introduction

At Deloitte's, (Stockholm), 2013 annual year end tax conference a couple of problems concerning foreign tax credits were on the agenda regarding technical service fees received by Swedish companies for services rendered to customers including their subsidiaries in Brazil, China and India, all of them BRIC countries where many of our multinational companies have big investments and manufacturing plants. Scania, for instance, is the largest manufacturer of trucks in Brazil and the Swedish government is in the process of concluding a contract for SAAB to deliver 36 fighter jets to Brazil. And Volvo Cars is building a large factory in China. In these fields of activity it can be expected that the rendering of technical services is very prevalent. Deloitte had experienced a number of cases where Swedish clients had paid excessive source taxes in these countries for which no credit relief had been granted in Sweden.

The domestic source tax rates in the said countries on service fees paid to tax payers other countries, as reported by Deloitte, are very high. China imposes 25% on the net income plus a 5% business tax (or a 6% VAT). In Brazil the tax is 15% on the gross amount and India charges no less than 27.4%. And on top of this the 22% Swedish corporate tax.

Deloitte suggested that the Swedish companies should consider setting up permanent establishments in these countries or try to channel the service fees through a subsidiary in some other country that would have a more favourable credit of foreign tax regime. All such remedies will, however, no doubt be costly and time consuming. Any attempt to rectify the situation by challenging the foreign tax administrations involved – i.e. bringing ones complaints to court in these countries – will no doubt be very complicated. Also discussed was to apply to the so called Swedish competent authority for our tax treaties for a proper application of the treaties that we have with China, Brazil and India. More herinafter.

With regard to Brazil and China there is, however, an approach to these problems that should be considered which could if not eliminate alltogether the double taxation that has occurred at least alleviate the situation to a certain extent . The problems regarding India are of a different nature and will be dealt with separately.

The approach suggested regarding Brazil and China focusses on the interpretation of the treaties involved with regard both to articles 7, 12 and 21 about business profits, royalties and other income and, most importantly, the elimination of double taxation article, (usually article 23 of our treaties). The discussion is of a general nature and can be encountered in all tax credit situations regarding our treaties.

The starting point in this analysis is to determine the nature of a (technical) service fee under the relevant tax treaty and the distributive rules that follow therefrom.

In doing so one will find that the treaties themselves with Brazil and China have no specific rules of what is meant by a service fee nor any distributive rule for determining the taxation of such fees. The nature of a service fee shall therefore be decided by the national laws of the country applying the treaty unless the context otherwise requires. (This method is laid down usually in article 3.2. of our treaties.)

Under Swedish tax law the determination of the nature of a service fee is uncomplicated. It allways constitutes (ordinary) business income. Many other countries in their national laws apply the same principle as Sweden when determining the meaning of the term service fees i.e. that they constitute business income. If so the application of the treaty is uncomplicated. According to article 7 business profits shall be taxed only in the country of residence of the recipient of the service fee i.e. in Sweden in this case unless the Swedish company has a permanent establishment in the source state (which for the purpose of this discussion is not the case.)

Some countries, however, may not consider service fees as business income under their national laws. It is understood that Brazil includes this type of income within the scope of royalties under their national law. This of course seems then to correspond to the term ”royalties” in article 12 of our treaties. However, the term ”royalties” as defined in article 12 subparagraph 2 does not cover or apply to service fees in the Brazil treaty. Consequently, article 12 for determining the taxing rights does not apply. Some other article in the treaty must be found for determining the application of the treaty with regard to service fees. The answer in this case should be that ncerned article 21 about ”other income” will determine the nature of a service fee according to the treaty. This article says that ”items of income not dealt with in the foregoing articles” shall govern the application of the treaty. In Sweden's treaties with both Brazil and China ”other income” arising in these latter states may be taxed primarily and without limit in these states.

Consequently a service fee under these treaties, when applied by Sweden, will be considered ordinary business income according to article 7 preventing Brazil and China to impose any source tax thereon whereas Brazil and China will invoke article 21 giving them primary right of taxation.

Brazil's viewpoint in this matter has incidentally been officially laid down in a Normative Instruction by the PGFN (Procuradoria-Geral da Fazenda Nacional) No.1/2000 under which it is understood that service fees should not be classified under Article 7, which provides that business profits of a resident company should only be taxed in the residence state, but rather under Article 21 or 22 ('Other Income'), in which case such income would also be subject to withholding tax (IRRF) at 15% in Brazil.

The rationale for China's claim to impose withholding tax is not known and was not discussed at the Deloitte meeting.

The consequence of the situation described is of course that the service fees will be subject to double taxation, something which under general treaty rules obliges the residence state to give relief herefrom. But, as reported, the Swedish tax administration/tax courts have denied such relief on the grounds, it is presumed, that the treaies have been erroneously applied by Brazil and China and that the tax payer should seek redress in these countries. However,these decisions, with all respect, are incorrect.

The problem that has arisen is often referred to in tax treaty situations as a ”qualification of income problem”, in this case where Sweden applies article 7 in the treaty but where Brazil and China apply article 21.

Qualification of income problems, which are not uncommon, are, however, specifically dealt with in our treaties namely in the elimination of double taxation article (usually) article 23. Accordinly, and in the very first sentence of this article, the residence state, Sweden, must provide credit if, ”under the laws of the other state and in accordance with the provisions of this Convention” tax has been charged in this other state.

The problem focusses specifically on the meaning of the second part of the above sentence ”in accordance with the provisions of this Convention”.

The understanding hereof is given in the Commentaries to article 23 of the OECD Model Tax Treaty. Under subtitle ”Conflicts of qualification” paragraph 32.2-3 the text reads:

”The interpretation of the phrase ”in accordance with the provisions of this Convention, may be taxed”...is particularly important when dealing with cases where the State of residence and the State of source classify the same item of income...differently for the purposes of the provisions of the Convention.

Different situations need to be considered in that respect. Where, due to differences in the domestic law between the State of source and the State of residence, the former applies, with respect to a particular item of income...,provisions of the Convention that are different to from those of of the State of residence would have applied to the same item of income..., the income is still being taxed in accordance with the provisions of the Convention, as interpreted and applied in the State of source. In such case, therefore, the two articles (23 A and B of the Convention) require that relief from double taxation be granted by the State of residence notwithstanding the conflict of qualification resulting from these differences in domestic law.”

Or in other words, if the service fees are taxable in Brazil and China under their domestic laws and are qualified by them as ”other income” under our treaties, Sweden as the State of residence must provide a credit for their taxes. The Swedish opinion that service fees represent business income under article 7 is irrelevant.

In conclusion, therefore, it is suggested that Swedish tax payers who have received service fees from Brazil or China shall insist, under the above interpretation of the treaty, that the Swedish tax administration provide a credit for the taxes levied in Brazil and China on their technical services fees. 

With regard to Brazil there is, however, good news for the future. The PGFN in 2013 has issued a new Opinion No.2363/2013 on the matter, recognising that its previous interpretatation - in accordance with a decision published in May 2012 by the Superior Court of Justice (STJ) which unanimously decided against the levy of IRRF on service fees - was incorrect and should be reassessed. Accordingly, remittances to non-residents as payments for services provided should now be considered as forming part of the non-residents company's profits and, as such, be taxable only in the residence state, in accordance with a correct interpretation of Article 7.

It is uncertain whether this new position by Brazil can be referred to for a reimbursement of past payments of tax. Probably not.

India.

With regard to India the problem discussed at the Deloitte seminar is completely different.

In the treaty with India there are indeed specific rules determining the nature of technical service fees and how they should be taxed. The meaning of what is meant by a service fee is thus taken care of in the treaty itself. In article 12 which incidentally is also titled ”Royalties and payments for technical services”, section 3.b), reads as follows: ” The term 'fees for technical services' means payment of any kind in consideration for the rendering of any managerial, technical or consultancy services including the provision of services by technical or other personnel...” Under section 2. of the same article the source state (India) may levy a tax of 10 percent of the gross service fee payment. And this, it appears, is also what has happened.

Sweden may also tax but under the elimination of double taxation article but must provide a credit for the 10 percent Indian tax that has been levied.This, it must be presumed, is also what has taken place.

But, as reported by Deloitte, this is not the whole story. In this specific case, one must also observe a special and extremely unusual provision tucked away in the special protocol of the Sweden-India treaty, a so called ”most-favoured-nation” clause applying to both dividends, interest payments as well as to royalties and technical service fees. It reads as follows:

”If India according to any treaty, agreement or protocol between India and a third State, which is a member of the OECD, reduces its source taxation under articles 10 (dividends), 11 (interest) or 12 (royalty and technical services fees) on dividends, interest or royalties and technical services fees to a lower level or limits its field of application of these incomes, the same level of tax or field of application in that treaty, agreement or protocol shall apply also according to this treaty.”

And, according to the information supplied by Deloitte at the seminar, India has indeed, since it made its treaty with Sweden (1997), concluded a treaty (with Finland) under which India, as source state, reduces its tax on technical services fees to nil. This, consequently, shall then apply also visavi Sweden according to our most-favoured-nation clause. India must therefore correct this situation by reimbursing the Swedish companies involved. In these cases the Swedish company should apply for help from the Swedish Competent Authority as discussed in the following section of this article.

Competent Authority responsibilities.

Where a treaty state has improperly applied a tax treaty it is allways possible , which was also recommended by Deloitte at their seminar, to seek redress herefor from the Competent Authority in the state of which the tax payer is a resident. This is laid down usually in article 25 of our treaties about the mutual agreement procedure. It applies both where the violation of the treaty has been comitted by the authorities or courts of the residence state and/or the source state.

As discussed above, the Swedish tax authorities must provide a credit for the foreign source taxes. If this is denied the company should approach the Swedish competent authority and ask them to deal with the matter. The competent authority has two options: It can either order the Swedish tax authorities to provide credit relief as discussed above or it can discuss the problem with the Brazilian and Chinese competent authorities suggesting that the business article (7) should apply and that the companies involved should be reimbursed for the foreign tax.

With regard to India it is important that the Swedish competent authority immediately sort the most-favoured-nation matter out with its Indian counterpart and see to it that the Swedish company is reimbursed for the tax it has paid in India on its service fee income.

Most-favoured-nation clauses, as afore mentioned, are very uncommon and indeed very difficult for an ordinary tax payer to keep track of. Therefore, it would be appropriate for the Swedish tax administration and/or the Swedish competent authority to follow up and provide information about all most-favoured-nation clauses in our treaties.

Conclusions and recommendations

The bottom line recommendation to Swedish companies encountering tax problems regarding service fees received from Brazil and China is to insist that a credit be granted in Sweden in accordance with the arguments presented in this article. Alternatively one should turn to the Swedish competent authority for help. Trying to sort these matters out with the tax authorities in Brazil, China or India or attempting to channel the service fees through other subsidiaries or setting up permanent establishments is going to be frustrating, expensive and time consuming.

The rendering of technical services to foreign clients and customers of Swedish companies account for a very important part of the Swedish economy and any double taxation of such income can be very costly for Swedish companies. It is therefore important that our treaty negotiators pay due attention to these problems and clarify the proper application of our treaties in this respect.

Deloitte have been invited to comment on this article but have declined to do so.

Stockholm November 2014.

peter.sundgren@gmail.com

070-491 76 70