European and International Tax Law - Key Concepts: Worldwide vs Territorial Taxation; Double Taxation and OECD MC (Dividends/Interest/Royalties)

Source of rules

  • Italian domestic tax rule: Testo Unico delle Imposte sui Redditi (TUIR) / Italian Tax Code (ITC)
  • European tax rules (ETR): European treaty, directives
  • International tax rules (ITR): OECD Model Convention and OECD Commentaries

Worldwide principle and territoriality principle

  • Domestic tax systems generally apply either:
    • Worldwide principle (unlimited tax liability) for residents: tax on income wherever sourced
    • Territoriality principle (limited tax liability) for non-residents: tax on income sourced within the territory
  • Cross-border transactions can create double taxation due to these opposing sovereignties
  • Double taxation can be juridical (same person taxed twice on same income) or economic (same income taxed twice in the hands of different taxpayers)

Juridical double taxation and Economic double taxation

  • Juridical double taxation (definition):
    • The imposition of comparable taxes in two or more States on the same taxpayer for the same subject matter and for identical periods
  • Economic double taxation (definition):
    • The same income is taxed twice, but to different taxpayers, i.e., the same economic transaction or income is taxed in two States, in the hands of different taxpayers

Residence State and Source State

  • Residence State (Home State): levies taxes on domestic and foreign income (worldwide principle)
  • Source State (Host State): levies taxes on income sourced within its territory by a non-resident (territoriality principle)

Recap 1-4: Example (1) – Overlap between residence and source taxation

  • Data (Example 1):
    • Income arising in residence country: 200
    • Income arising in source country: 100
  • Taxation in residence state (worldwide): 300 total on worldwide income
  • Taxation in source state: 100 on source income
  • Consequence: Overlap creates potential juridical double taxation on the 100 portion of income that is taxed by both states
  • Conceptual takeaway: Two criteria for tax liabilities in different states exist: Residence (worldwide) vs Source (territorial)

Recap 1-4: Example (2) – Tax rates and double taxation relief

  • Data (Example 2):
    • Source country income: 100
    • Tax rate in source country: 30%
    • Worldwide income subject to tax by residence country: 300
    • Residence tax rate on worldwide income: 40%
  • Calculations:
    • Tax by source country on source income: 100 imes 0.30 = 30
    • Tax by residence on worldwide income: 300 imes 0.40 = 120
  • Total tax faced (without relief): 150 (30 + 120)
  • Illustrates double taxation on the source income of 100 via both states

Recap 1-4: Example (3) – Relief mechanisms and treaties

  • In the absence of a tax treaty, the source country typically does not reduce double taxation
  • Relief options:
    • Residence country may provide unilateral double taxation relief
    • If a tax treaty applies, the source country may be required to refrain from taxing the non-resident entirely or partially (e.g., permanent establishment rules under Art. 7 OECD MC, or reduced withholding rates under treaty provisions)
    • Residence country may apply exemption or credit methods for relief

Content 1–4: Article 10 OECD MC – Dividend (overview)

  • Article 10(1): Dividends paid by a resident company to a resident of the other Contracting State may be taxed in that other State
  • Definitions (as used in Art. 10):
    • SubCo: a company
    • HolCo: a company that is resident and taxed in its own state
    • Resident: a person liable to tax in their State of residence
    • The concept of a company includes entities treated as a body corporate for tax purposes
  • Residence State vs Source State (conceptual):
    • Residence State taxes on worldwide income; Source State taxes income sourced within its territory

Content 1–4: Article 10 – Preliminary (distribution mechanics and two main rules)

  • Dividend distribution mechanics:
    • A company (distinct from shareholders) is taxed on its profits first; profits are not attributed to shareholders (except CFC situations)
    • Dividends are income from capital invested in the company
  • Two main rules from Article 10(1) context:
    • Principle of concurrent taxation: may be taxed in both States when dividends are paid cross-border
    • State of Residence is entitled to tax dividends on worldwide income, including those distributed from source to residents

Article 10(2) – Dividend (limitation on source-state taxation)

  • OECD MC states: dividends paid by a resident company to a resident of the other Contracting State may also be taxed in that state, but limitations apply if the beneficial owner is in the other State:
    • a) 5% of the gross amount if the beneficial owner is a company that directly holds at least 25% of the paying company's capital for a 365-day period including the payment day (ownership changes due to mergers/divisions are excluded for computation)
    • b) 15% of the gross amount in all other cases
  • Competent authorities of the Contracting States must settle the mode of applying these limitations by mutual agreement
  • This paragraph does not affect taxation of the company profits out of which the dividends are paid

Article 10(2) – Dividend (interpretive notes and BEPS modification)

  • The 5%/15% caps are distributive rules (they decide how to share taxing rights between the two States)
  • BEPS Action 6 modification (Action 6 OECD/G20 BEPS Project) clarified and limited the operation of para 2(a):
    • Restricts its application to situations where the recipient holds directly at least 25% of the paying company's capital throughout 365 days including the payment day
    • The computation cannot account for ownership changes during the year (e.g., mergers) intended to gain the benefit
  • Implication: prevents treaty-shopping schemes where a shareholder increases its stake temporarily to qualify for the lower rate

Article 10(2) – Dividend Beneficial Owner

  • Beneficial owner concept: the entity that ultimately enjoys the economic benefit of the dividend; not merely a formal owner or intermediary
  • The owner must be the person who has the right to use and enjoy the dividend free from contractual/legal obligations to pass on to another
  • Even if there is a beneficial owner, the treaty-based reduction may be denied if the arrangement constitutes abuse (e.g., treaty-shopping scenarios)
  • Illustrative example (conceptual):
    • Co/Co: an agent or nominee located in a third state can still be treated as recipient for purposes of the treaty; WHT rates depend on the DTT terms rather than mere nominal ownership
    • Example setups: Italy–USA vs Italy–Germany treaties show different WHT outcomes depending on beneficial owner status and treaty terms

Article 10(2) – Dividend Beneficial Owner (detailed rules)

  • No beneficial owner occurs if:
    • Formal owner only
    • Very narrow powers in practice
    • Acts on account of interested parties
    • Right to use and enjoy the dividend is constrained by contractual/legal obligation to pass on the payment to another person
  • Conversely, if the recipient can use and enjoy the dividend without such constraints, they are the beneficial owner
  • Even with beneficial owner status, the dividend limitation may not automatically apply in cases of abuse or treaty-shopping

Article 10(2) – Dividend Beneficial Owner (practical examples)

  • In cross-border setups, the presence of an agent/nominee in the chain does not automatically defeat the beneficial owner status if the actual beneficial owner is resident in the other State and the treaty allows relief
  • The example in slides shows: a co/agent can qualify as resident in a third country (e.g., USA) for WHT purposes under a DTT, but treaty purposes depend on object/purpose of the Convention

Article 10(3) – Dividend (definition of dividends)

  • OECD MC defines dividends as: income from shares, jouissance shares or jouissance rights, mining shares, founders’ shares or other rights that are taxed similarly to shares by the resident state
  • Not an exhaustive definition due to varying national rules; para 3 provides representative examples used in many jurisdictions

Article 10(4) – Dividend (PE/Art. 7 interaction)

  • If the beneficial owner carries on business in the other State through a permanent establishment (PE) connected to the holding, Article 7 applies
  • Dividends taxed as profits of the PE if connected to the PE
  • Distinction points:
    • Mere recording of the holding in the PE’s books may not imply profits attribution
    • Economic ownership concepts may affect the link between the holding and PE when profits are attributed

Article 10(3)–10(4) – Practical notes

  • The distributive nature of Article 10 means it allocates taxing rights between Source and Residence States, but does not itself prescribe all domestic tax outcomes
  • Practical implications include interplay with CFC rules, PE rules, and anti-abuse measures

Article 11 – Interest (overview)

  • Article 11(1): Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State
  • Article 11(2): Interest may also be taxed in the state where it arises according to its laws, but if the beneficial owner is a resident of the other State, the tax shall not exceed 10% of the gross amount
  • The competent authorities shall settle the method of applying this limitation by mutual agreement
  • Conceptual takeaway: concurrent taxation is allowed; source-state may tax, but limit applies when beneficial owner resides elsewhere
  • Beneficial owner concept applied to interest similarly to dividends; it determines who benefits from the rate limitation

Article 11 – Interest (example framework)

  • Example setup with SubCo and HolCo illustrates concurrent taxation rights based on source and residence
  • The beneficial owner criterion remains central to applying the 10% cap

Article 12 – Royalties (overview)

  • Article 12(1): Royalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the other State (source-state taxation is limited)
  • Article 12(3): The provisions of para 1 shall not apply if royalties are connected with a PE; then Article 7 applies
  • Beneficial ownership concept also governs royalties similarly to dividends/interest

Article 12 – Royalties (DTT specifics and exceptions)

  • DTT [USA-ITA] in bilateral relations replaces the exclusive taxation principle with concurrent taxation under the treaty
  • Article 12(1): Royalties may be taxed in the other State
  • Article 12(2): Royalties may also be taxed in the State where they arise, but if the recipient is the beneficial owner, the tax shall not exceed:
    • (a) 5% of the gross amount for royalties for the use of software or industrial, commercial, or scientific equipment
    • (b) 8% of the gross amount in all other cases

Article 12(4) – Royalties (arm’s length and excess payments)

  • If there is a special relationship between payer and beneficiary or related parties, and the amount paid exceeds the amount that independent parties would have agreed upon, the excess is taxed according to the laws of each Contracting State, with other MC provisions considered
  • This mirrors the transfer pricing risk that under-pins royalty/interest payments

Article 11(6) – Article 12(4) – Arm’s length and excess payments (anti-abuse concept)

  • The sections cited (Art. 11(6) and Art. 12(4)) address cases where related-party payments exceed arm’s-length terms
  • Practical effect: the excess portion remains taxable under domestic law in each State, ensuring alignment with transfer pricing principles

Practical examples: “Co/Co” and Beneficial Owner diagrams

  • The slides provide simplified diagrams showing how beneficial owner and agent/nominee structures affect WHT under various DTTs (ITA-USA vs ITA-GER)
  • Key takeaway: the beneficial owner concept and treaty provisions determine whether a reduced WHT applies

Dividend: Italian Tax Code Article 44(2) (ITC)

  • Italian ITC Article 44(2) defines dividend-like remuneration for tax purposes:
    • Securities and financial instruments issued by group entities, where remuneration consists of participation in profits, may be treated similarly to shares
    • Participations in capital or assets and certain instruments issued by related entities may be deemed similar to shares if related remuneration is non-deductible in the foreign residence state
  • The non-deductibility must be evidenced by issuer declarations or other precise elements

Summary of key formulas and concepts

  • Tax relief methods (Residence vs Source):

    • Exemption method (foreign-sourced income exempt from domestic tax)
    • Credit method (foreign tax credit against domestic tax on foreign income)

  • General relief formula (illustrative):

    • If TW is the tax on worldwide income in the Residence State and TF is foreign tax paid, then the Residences’s tax payable can be expressed as:

      ext{Tax payable} = T_W - ext{Credit}

      ext{Credit} = egin{cases}
      ext{min}(TW^{foreign}, TF) & ext{credit limited to foreign tax or to tax on foreign income}
      \
      0 & ext{if exemption method is used}

      ext{(simplified depiction; actual law may vary by jurisdiction)}

  • Treaty-based withholding rate caps (Art. 10(2), Art. 11(2), Art. 12(2)):

    • Dividends: $$ ext{WHT}_{10(2)} = egin{cases} 0.05 & ext{if beneficial owner holds ≥25 hpercent directly for 365 days} \ 0.15 & ext{otherwise} \ ext{(subject to mutual agreement)}
      \

    \ 0.10 ext{ (for interest, per Art. 11(2))}

    \

  • Royalties rate caps (Art. 12(2)):

    • 5% for royalties for the use of software or for certain equipment
    • 8% for all other royalties

  • Arm’s-length principle (Art. 11(6) and Art. 12(4)):

    • If there is a special relationship and payments exceed the arm’s-length amount, the excess remains taxable according to each State’s laws, taking into account other provisions of the Convention

  • PE interaction (Art. 10(4)):

    • If the beneficial owner has a PE in the source State and the holding is connected with the PE, Article 7 applies; dividends are taxed as profits of the PE

Additional notes on practical interpretation

  • Distributive rules under Art. 10: the DTT determines how taxing rights are distributed between source and residence States
  • Beneficial owner concept is central to applying reduced withholding rates and to avoid treaty shopping
  • Treaties can modify the default exclusive taxation of royalties (Art. 12(1)) to concurrent taxation in some bilateral arrangements (e.g., USA-Italy)
  • The Italian ITC treatment of dividends under Article 44(2) highlights domestic rules for determining whether certain distributions are treated as dividends for tax purposes, including non-deductibility of certain cross-border remuneration and the need for issuer declarations or precise evidence

Practical takeaways for exam preparation

  • Distinguish between worldwide vs territorial taxation and identify which State acts as Residence vs Source in given scenarios
  • Be able to classify double taxation as juridical or economic and explain the relief mechanisms (exemption vs credit)
  • Memorize key numeric caps and thresholds for Art. 10(2): 5% vs 15% and the 25% direct ownership over 365 days requirement (and BEPS corrections)
  • Understand the Beneficial Owner concept and how it affects treaty relief, including abuse scenarios
  • Recognize the interaction between Art. 10, Art. 11 (Interest), and Art. 12 (Royalties) and how the distributive rules allocate taxing rights
  • Recall the PE exception under Art. 10(4) and the Art. 7 tie-in for profits linked to PE
  • Know that Article 12(3) permits taxation by the source State when royalties are connected to a PE under Article 7
  • Be familiar with how unilateral relief (by the residence State) complements or substitutes treaty relief in the absence of a treaty
  • Appreciate the real-world significance of BEPS BEPS Action 6 changes for withholding taxes and treaty shopping
  • Understand that DTTs can modify domestic tax outcomes, and that domestic definitions (e.g., dividends under national tax code) can affect cross-border tax treatment