LexisNexis

Most favoured nation clause applicable to royalties covered by the Colombian tax treaty network

Wednesday 6 April 2022

Maria Fernanda Rubio

Brigard Urrutia, Bogotá

mrubio@bu.com.co

Colombia has 11 bilateral double taxation treaties (DTT) in force to date, all based on the Model Tax Convention of the Organisation for Economic Co-operation and Development (OECD).[1] The majority of these DTTs contain most favoured nation clauses (MFNCs).

This article focuses on MFNCs included in Colombia's DTTs as applicable representatives of income typically covered by Article 12 (Royalties). Therefore, this article does not include references to other types of income that might be covered by other MFNCs (eg, dividends and interest).

Broadly, an MNFC implies that both contracting states agree that if one of them has more favourable conditions with a third state in respect of specific income covered by the DTT, such provisions automatically apply to their own DTT as if these provisions were included in that agreement.

Given the significant effect that the MNFC may have, it does not apply in general or in respect of all types of income covered by a given treaty. Rather, it deals with specific items of income covered by particular articles of a DTT.

For many years, Colombia did not need to analyse the application of MNFCs because the tax treatments established in Article 12 of the DTTs in force were very similar; specifically, the definition of 'royalties' expressly included 'technical services', 'assistance services' and 'consulting services', and in all treaties, the definition was the same. As a consequence, as per Article 12 of all DTTs, payments for these items were considered as royalties and were taxed in the source state at a maximum rate of ten per cent (typically via withholding).

Pursuant to the above, although most DTTs included an MFNC, it was not triggered because no treaty allowed for most favourable treatment. This remained the case for many years, and the MFNC appeared to be important only for academic purposes and was not dealt with in practice or by the tax authority.

This situation changed as of 1 January 2020, when the DTT with the United Kingdom (UK DTT) entered into force. Under the UK DTT, payments for technical services, technical assistance and consulting services are neither dealt with by Article 12 nor other articles. Accordingly, these payments are not treated as royalties, and have to be covered by some other broader provision. As a result, it was concluded that: (1) the nature of these payments changed in the UK DTT, and hence; and (2) these payments are covered by Article 7 or Article 21, as the case may be, according to which, said payments are not taxed in the source state but in the residence state, absent a permanent establishment (PE).

Hence, older DTTs taxed those payments in the source country and UK DTT in the residence country. This situation is summarised as follows:

Treaty

Taxation in the source state

Taxation in the residence state

UK DTT

No, provided that the income is not attributable to a PE in Colombia

Yes

Other DTTs

Yes, royalties arising in Colombia and paid to a resident of the other contracting state may be taxed in Colombia and according to its laws, but if the beneficial owner of the royalties is a resident of Canada, the tax so charged shall not exceed ten per cent of the gross amount of the royalties

Yes, but methods for the elimination of double taxation are agreed in the DTTs

The new qualification of technical services, technical assistance and consulting services agreed in the UK DTT obliged Colombian taxpayers to analyse other DTTs entered into by Colombia to determine whether, as of 1 January 2020, this new situation affected the manner in which they are construed and applied and, if so, if payments for technical services, technical assistance and consulting services made by a Colombian resident to a resident in the other contracting state would be taxed in Colombia (source state) or the other state (residence state).

In anticipation of several consultations from taxpayers, tax advisers and so on, Colombia's National Tax Authority (Dirección de Impuestos y Aduanas Nacionales or DIAN) issued a general ruling[2] regarding the application of the MFNCs included in Colombia's DTTs. The ruling specified which of those DTTs could be altered by virtue of the change in the UK DTT. To that end, the tax authority analysed the specific wording in each of the MNFCs of the applicable treaties.

The following chart explains DIAN's conclusions:

Treaty

Wording of the MFNC regarding royalties

Change because of UK DTT

Spain

MFNC is triggered if Colombia agrees a lesser tax rate with a third state.

DIAN explained that 'tax rate' means the 'percentage that is applied to the taxable base to calculate tax'.

No. As per the wording of the Spain DTT, the change only applies if a lower percentage is agreed with a third state and a change to the nature of the payments in the UK DTT was agreed but not a lower percentage.

Mexico

MNFC is triggered if Colombia agrees a lesser tax rate with a third state or if it is agreed that the technical services and technical assistance service have a different nature than royalties. The clause did not include payments for consulting services.

Yes. The UK DTT excludes payments for technical services and technical assistance services from the article on royalties, which leads to a modification to their nature. Hence, the MFNC in the Mexico DTT is triggered.

The aforementioned implies that payments for technical assistance services and technical services (not consulting services) are not covered by the article on royalties and are now covered by articles on business profits or other income.

Chile

MFNC is triggered if Colombia agrees an exemption or a decrease in the rate with a third state upon payments for technical services, technical assistance services or consulting services.

No. The exclusion of payments from the article on royalties agreed in the UK DTT does not imply an exemption (ie, preferential treatment for a particular matter) nor a lower rate.

Czech Republic

MFNC is triggered if Colombia agrees a more favoured rate with a third state than that set out in Article 12 or most favoured treatment.

Yes. Granting tax treatment that results in a non-taxation effect in the source state is most favoured treatment.

Canada

MFNC is triggered if Colombia concludes a most favoured provision with a third state in respect of technical assistance, technical services or consulting services.

Yes. The exclusion of services from the article on royalties is considered as more favourable treatment.

Portugal

MFNC is triggered if Colombia concludes a most favoured provision with a third state in respect of technical assistance, technical services or consulting services.

Yes. The exclusion of services from the article on royalties is considered as more favourable treatment.

Switzerland

MFNC is triggered if Colombia agrees a tax rate with a third state less than that agreed in this DTT.

DIAN explains that 'tax rate' means the 'percentage that is applied to the taxable basis to calculate tax'.

No. As per the wording of the Switzerland DTT, the change only applies if a lower percentage is agreed with a third state and in the UK DTT, a change to the nature of the payments was agreed but not a lower percentage.

After the cited ruling was issued, a wide array of opinions emerged in connection with the tax authority's interpretation of MFNCs. The main concerns raised by many taxpayers and tax professionals can be summarised as follows:

  • DIAN is not the authority that should interpret the DTTs;
  • this interpretation prevents the country from being more competitive compared with other countries that have not included technical services, technical assistance services and consulting services in Article 12 (Royalties) of their DTTs;
  • as per the 'pacta sunt servanda' principle set forth in Article 26 of the Vienna Convention on the Law of Treaties, parties to a DTT have clearly agreed to obtain a benefit granted to a third state. Under DIAN's interpretation, this objective would be trumped and the rules of DTTs would be rendered inapplicable despite the intent of the signing states; and
  • regarding the Swiss DTT, the following contradiction arises: the DTT was signed in Spanish and French, both languages with the same force. In Spanish, the MFNC wording refers to a 'tipo impositivo' ('tax rate') agreed with a third state that is lower than that agreed in the Swiss DTT. However, the French wording of the MFNC refers to a 'régime d'imposition' ('tax regime') agreed with a third state that is more favourable than that agreed in the Swiss DTT. This poses a clear and significant question: Should the Swiss MFNC be triggered when a subsequent treaty provides for a lower tax rate or when it provides for a more favourable tax regime? This issue was not addressed by DIAN and, in our opinion, should be tackled through a mutual procedure agreement between the competent authorities as established in the same DTT. In any case, following the objectives of the DTT, it appears that the interpretation should be the latter (ie, the more favourable regime).

Note that the aforementioned ruling did not refer to all DTTs entered into by Colombia because a couple of them did not include an MFNC (ie, India and South Korea) and a couple were not yet in force when the ruling was issued (eg, Japan and the United Arab Emirates, which also fail to include the MFNC, and France and Italy, referred to further below because they came into force after the ruling but prior to this document).

The DTT with France will apply as of 1 January 2023. In this particular treaty, payments for technical services, technical assistance and consulting services are not expressly included in Article 12. Therefore, any such payments will be covered by other articles of the DTT (eg, Article 7 or 21, as the case may be).

Finally, the DTT with Italy applied as of 1 January 2022, and also excludes payments for technical services, technical assistance services and consulting services from Article 12. In fact, Protocol (8) of the DTT explains that these services are deemed to be covered by Article 5 (Permanent Establishment), 7 (Business Profits) or 14 (Independent Personal Income) according to which, they would be taxed in the residence state unless they are attributable to a PE located in the source country.

Notes


[1] Canada, Chile, the Czech Republic, France, India, Italy, Japan, Mexico, Portugal, South Korea, Spain, Switzerland, the United Arab Emirates and the United Kingdom are not in force yet.

[2] Official Ruling 3283 of 17 February 2020.