All corporate houses, big and small around the globe constantly seek in financial innovation in raising capital and in allocating rights over sharing of profits. From a plain vanilla equity to participative debt securities to complex warrants etc. of the hybrid derivative clan, there is no dearth of cutting-edge financial instruments. Of course, not to forget the perks they offer to issuers, investors and to the tax consultants!
The European Court of Justice (‘ECJ’), exercising arbitration procedure under Article 273 of the Treaty on the Functioning of the European Union (‘TFEU’) interpreted the term ‘debt-claims with participation in profits [See end note 1] appearing in Article 11(2) [See end note 2] of the Austro-German Double Tax Avoidance Agreement (‘DTAA’) [See end note 3] . It is significant to note that, this is the first time the doors of the ECJ have been knocked taking recourse to Article 25 (5) of the DTAA for resolving disputes between two Member States in a tax treaty context.
The brief facts of the case are that Bank Austria AG (‘Austrian Bank’) which has its seat in Republic of Austria purchased certificates (Genussscheine) from Landesbank NRW (‘German Bank’), based in Federal Republic of Germany. Genussscheine or certificates are hybrid form of financial instruments issued by corporates which generally have characteristics of either equity or debt or both. The certificates issued by the German bank conferred upon the holder the right to receive fixed percentage of interest annually, subject however to the German Bank making accounting profits. In the event of losses, the interest payment is reduced with a right to receive deficit as arrears in subsequent years when profits are made. The holder, in this case, the Austrian Bank did not have any right to participate in the proceedings of winding up.
The dispute before the ECJ was whether the certificates issued by the German Bank to the Austrian Bank also conferred rights to participation in profits. The issue arose out of Article 11 of the DTAA which deals with tax treatment of interest income earned by the residents of the respective States. Explained lucidly, Article 11(1) grants the right to tax interest income to the State in which the holder of the instrument resides or the place where the beneficial owner is established i.e. in Austria. On the contrary, Article 11 (2) vests the taxing rights with the State of source provided the interest is earned out of debt-claims with participation rights in profits, in the present case, Germany.
The Republic of Austria contended that the certificates issued by the German Bank cannot be categorized as debt claims with participation rights in profits and therefore Austria should get the exclusive right to tax the interest income. The Federal Republic of Germany on the other hand contended the contrary by placing reliance on the decision of Federal Finance Court of Germany rendered on 26th August 2010 in IR 53/09.
In this background, the ECJ referred to Article 3 (2) of the DTAA. Article 3 sets out the rule of interpretation of treaties and as per Article 3(2), a term or phrase not defined in the DTAA must be interpreted by giving the meaning it has under the tax law of the State applying it. The ECJ, although referring to Article 3 (2), observed that while resolving disputes between two States, such a rule of interpretation by a single State at a given point in time is not to be regarded as a rule. The ECJ referred to Article 31(1) of the Vienna Convention on Law of treaties (‘VCLT’) which reads as “A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose” and held that a term not defined in any tax treaty must be interpreted according to the methods proper to international law. Preferring the rule of interpretation as per VCLT over Article 3 (2), the ECJ ordered that the interest income earned from the certificates issued by the German Bank is not in the nature of ‘debt-claims with participation rights in profits’ to warrant invocation of Article 11(2) of the DTAA.
In concluding so, the ECJ observed that the phrase ‘participation in profits’ is to be understood in a scenario where the interest receivable is uncertain at the commencement of the year and varies based on the profits of the business which cannot be predicted. Sometimes, the interest receivable could be as low as zero if the business incurs a loss. In the present case, the interest receivable is a determined fixed percentage, though the incidence of payment depends on the profitability. Further, the ECJ also found support to its reasoning by referring to the list of financial instruments covered by Article 11 (2), all of which suggest that the income receivable varies/ should vary depending on the annual profits.
This decision of the ECJ is a landmark ruling with regard to treaty interpretation in the Indian context as well. By way of a protocol entered into between the Republic of India and the Federal Republic of Germany on 19th June 1995, the phrase ‘debt-claims carrying a right to participate in profits’ finds place in Article 10 and 11 and the taxing right is vested equally in both the States by the usage of word ‘may’ in the said Article.
It is of relevance to note that the decision of the ECJ is silent if the phrase ‘debt claims with participation rights on profits’ was defined either in the domestic law of Austria or Germany. Without such an observation, it has categorically rejected the application of Article 3 (2) to the case in hand.
This leads us to the crucial question whether a term, not defined in the treaty, can be interpreted without taking recourse to Article 3 (2) as is the stand taken by the ECJ.
VCLT being an international customary law [See end note 4] is applicable to States irrespective of whether such States are a party to it [According to Ned Shelton [See end note 5] ‘If we accept that Vienna Convention is an accurate codification of customary international law, the rules of interpretation laid down in the Vienna Convention are also applicable to states which have not ratified or acceded to it, on the basis that they too must respect customary international law. This is of special importance to those countries which have entered into tax treaties but which are not parties or even signatories to the Vienna Convention such as India, Ireland, France and South Africa]. The authors are of the view that, the presence of Article 3(2) specifically in any tax treaty, makes it compulsory and binding on the parties to the treaties to refer to the domestic law meaning of an undefined term. In this regard, the concept of Pacta Sunt Servanda under Article 26 of the VCLT specifies that “every treaty in force is binding upon the parties to it and must be performed by them in good faith”. Therefore, without applying Article 3 (2), the general rule of interpretation under VCLT cannot be resorted to or in other words Article 3 (2) read with Article 26 of the VCLT cannot be bypassed to apply the general rule of interpretation as per Article 31 (1) of the VCLT.
We find support in the words of Klaus Voge [See end note 6] wherein while dealing with Article 3 (2), he states, Article 3(2) of OECD and UNMC can also be regarded as a procedural rule. The interpretation in the light of domestic law constitutes the default rule. The burden of proof lies on the person who wants to deviate from the domestic law meaning to find strong arguments in favor of a contextual interpretation. Per Klaus Vogel, the order of reference in interpreting terms in a treaty is as below:
- First, special treaty definitions, will be applied.
- If no such special rules are applicable the question to be asked is whether the law of the State applying the treaty (lex fori) attaches a special meaning to the term to the extent that it relates to the taxes covered by the treaty.The same question has to be asked if the treaty definition is not exhaustive or if the context requires not to apply the definition.
- If the law of the State applying the treaty uses the term the terms’ meaning needs to be ascertained in order to ask whether the context suggests a different interpretation and, in the light of the weight to be given to alternative interpretations, whether the context requires a different interpretation.
- If question (2) is answered in the negative, the general rules of interpretation should apply.
To conclude, if the ruling of the ECJ is taken as a binding precedent, then it may lead to a situation where, reliance would be placed on the general rule of interpretation as per Article 31 (1) of VCLT in every case where a term is not defined in a tax treaty, even though that term is given a meaning under the domestic legislation of the State(s) applying it. This may render Article 3(2) of the DTAA otiose, which cannot be the intention of the negotiating parties and which is also contrary to the generally understood principles of International taxation.
[The authors are Senior Associates, Direct Tax Practice, Lakshmikumaran & Sridharan, Chennai ]