Treaty override Domestic Law – A global roundup

Dr. M.S. Vasan, Managing Partner, MSV Legal (Assisted by Anmol Anand, LLM in Taxation,  George town University Law Centre , Washington DC, USA)

Article 27 of the Vienna Convention on the Law of Treaties¹ provides that treaties are binding and the domestic constitutional law cannot serve as a basis for failure of good-faith compliance.  Every treaty in force is binding upon the parties to it and must be performed by them in good faith -"PACTA SUNT SERVANDA".  As per Article 18 , “A State is obliged to refrain from acts which would defeat the object and purpose of a treaty when:

• it has signed the treaty or has exchanged instruments constituting the treaty subject to ratification, acceptance or approval, until it shall have made its intention clear not to become a party to the treaty; or
• it has expressed its consent to be bound by the treaty, pending the entry into force of the treaty and provided that such entry into force is not unduly delayed.”

The only aspect to be looked into as per Article 46 is that it should not be in violation of a provision of its internal law regarding competence to conclude treaties which is of fundamental importance. Income tax treaties are negotiated in a way to reflect the policy of the revenue and treasury departments of contracting states and tend to override existing internal laws according to their terms. Later enacted statutes (including amendments to existing laws) may conflict with a treaty provision, thereby leading to breach of treaty obligations and giving rise to grounds for a claim for restitution, or to retaliate, or abrogate the treaty, as the treaty or international law or the country’s view may allow, however it seems unlikely that the taxation of an income would be so serious, that an event like that would occur.

BEPS Action 15, 2015 final report also enumerate that the sovereign autonomy is the basic principle underpinning the international order particularly, in tax matters. The concept of sovereignty underpins the stable tax framework within which governments have been able to facilitate arrangements that allowed for the benefits of globalisation to flow to all market economies. An urge has been felt by G20 / OECD that there shall be new provisions – anti-treaty abuse in relation to hybrid mismatch arrangements and the compatibility with tax treaties of certain anti-BEPS measures. Domestic laws should express the commitment to the measures agreed under multi-lateral instruments to address treaty-based BEPS issues.

The Supreme Court of India in Ram Jethmalani v. Union of India [TS-5017-SC-2011-O] recognized the customary status of the Vienna Convention despite India not having ratified the convention yet. The courts in India have been leaning towards the principles of pacta sunt servanda and general rules of interpretation of a treaty, as contained in the Vienna convention, to embrace good faith compliance.

In Vodafone South Ltd., [TS-173-HC-2014(KAR)-O] it was held that any unilateral amendment or revocation of any clause in the domestic law contrary to what was agreed to and signed by both countries under DTAA, is a recognised sovereign power of the Legislature.

In Nokia (DIT v Nokia Networks OY and Ors. [TS-700-HC-2012(DEL)-O], it was held that retrospective amendments made to the definition of royalty under the Income Tax Act had no bearing on transactions taxed under DTAAs as the payment received was towards the title and GSM system of which software was an inseparable parts incapable of independent use and it was a contract for supply of goods.

However, in a recent Madras High Court decision [TS-5191-HC-2016(Madras)-O], it was observed that the Vienna Convention could not be invoked to prevent one contracting state from taking recourse to domestic law, when the other contracting state failed under its obligations of good faith compliance [at para 88.]. A Special Leave Petition has been filed by the petitioners before the Supreme Court against the Madras High Court decision which has recently been accepted. Hence, this matter is now before the Supreme Court.

Section 90 of the Indian Income Tax Act (“the Act”) empowers the Central Government to enter into an agreement with a foreign government for various purposes including avoidance of double taxation and exchange of information. Section 90(2) of the Act gives the taxpayer an option to choose between the Act and the treaty; whichever is more beneficial to him. It was observed in Azadi Bachao Andolan [TS-5-SC-2003-O] and in Kulandagan Chettiar [TS-34-SC-2004-O]  that a tax treaty overrides the provisions of the Act in the matter of ascertainment of income and its chargeability to tax, to the extent of inconsistency with the terms of the treaty. This observation was primarily based on the inclusion of the phrase “subject to the provisions of this Act” under section 4 and 5 of the Act (“charging provisions”).

The Delhi High Court in New Skies Satellite BV [TS-5188-HC-2016(Delhi)-O] and Shin Satellite [TS-5188-HC-2016(Delhi)-O] also held that amendments to domestic tax laws could not result in amending any tax treaties entered into with other jurisdictions. The Court further observed that the Parliament even though the supreme legislative body cannot unilaterally amend the treaty. It is certainly true that law laid down by Parliament in our domestic context, even if it were in violation of treaty principles, is to be given effect to. But where the State unilaterally seeks to amend a treaty through its legislature, the situation becomes quite different from when it breaches the treaty. Hence, the courts in India thus far favoured the treaty law over the domestic law amendments.

However, the recent Madras High Court Judgment [TS-5191-HC-2016(Madras)-O] followed another Supreme Court judgment Jolly George Varghese Vs. The Bank of Cochin [AIR 1980 SC 470], that held that the Indian Constitution follows dualistic approach in [at para 75-76] with respect to international law, which assumes that international law and internal law of States are two separate and distinct legal systems, and hence an International Treaty could be enforced only so long as it is not in conflict with the laws of the State. The Court also observed that a Treaty would have to be made into an Act of Parliament to form part of internal law, whenever such Treaty operates to restrict the rights of citizens or others or modifies the laws of the State in Magan Bhai Patel Vs. Union of India [AIR 1969 SC 783]. Hence, the court concluded by observing that it would be in contravention of the constitutional scheme, if the power of the Parliament were to become limited in formulating a law (or amendment) with respect to a treaty (even if inconsistent with the treaty) in [TS-5191-HC-2016(Madras)-O] [at para 83]. Although, this finding is in concurrence with the Constitution, the Court seems to have contradicted its own finding with respect to “good faith compliance” principle under the Vienna convention, as aforementioned. The petitioners have filed a SLP before the Supreme Court which has recently been accepted. It will be interesting to know the Supreme Court’s view on this issue, especially since the High Court observed that charging provisions were indeed subject to the provisions of section 90 in [TS-5191-HC-2016(Madras)-O] [at para 77]  as concluded by Azadi Bachao Andolan [TS-5-SC-2003-O], while drawing the conclusion that Parliament could make laws on the matters exclusively covered by the tax treaties. This conclusion of the court seems to be a defence mechanism, driven by the fact that Cyprus did not comply with the exchange of information clause under the treaty and abuse of treaty benefits by taxpayers in [TS-5191-HC-2016(Madras)-O] [at para 91 and 94], rather than being based on sound principles of customary international law.

In USA , the Congress codified the rule in 1988 as section 7852 that reflects the guiding principle that neither U.S. tax law nor a treaty has precedence over the other “by reason of its being a treaty or law”. Thus, later statutes displace earlier statutes or inconsistent treaties and later treaties displace earlier treaties or inconsistent statutes (“later-in-time” rule).² Congress generally is explicit when it intends tax legislation to override provisions of existing tax treaties.³ U.S. courts, however, tend to apply the later-in-time principle cautiously, using an initial presumption of harmonious reading of statutes and treaties. ⁴ Since repeal by implication are not favoured in the US, where there are two acts upon the same subject, effect should be given to both if feasible.⁵

With income tax treaties that conflict with earlier-enacted statutes, the application of the later-in-time principle is more straightforward. The language of section 894(a)(1)⁶ recognizes that tax treaty provisions may modify the way that U.S. domestic tax rules apply to certain incomes or gains or to certain persons.

With respect to conflicts with the state law, the treaty provisions prevail.⁷ In practice, however, such conflicts rarely occur because U.S. tax treaties generally restrict their coverage to federal taxes and do not purport to directly alter the application of a tax imposed by a state or locality.⁸ Nevertheless, the non-discrimination articles in many U.S. tax treaties do apply to state and local taxes (as well as to federal taxes) and, under the Supremacy Clause, will therefore prevail over inconsistent state law.⁹

FATCA introduced by the USA imposed a new condition on the withholding tax rates enjoyed as per the DTAA for dividends, interest and capital gains ( say 0,10% or 15% as the case may be). Every person earning such incomes , being a Canadian resident should provide information and fulfil reporting requirements to enjoy the treaty rate. Otherwise, domestic rate for passive incomes at 30% shall apply. This was construed as domestic law override treaty provisions.

The US Model Income Tax Convention 2016, includes a new article 28 that obligates the treaty partners to consult with each other to amend the treaty as necessary, when changes in the domestic law of a treaty partner draw into question the treaty’s original balance of negotiated benefits and the need for the treaty to reduce double taxation.

Germany arguably follows a dualistic approach. A treaty only becomes applicable under domestic law if the parliament “transforms” the treaty into domestic legislation. The constitution is always ranked on the highest level followed by laws enacted by the parliament¹⁰ and regulations enacted by the parliament. Tax treaties have the same rank as federal laws enacted by the parliament. Therefore, tax treaties prevail over governmental regulations at the federal level, as well as over all law provisions on the level of the states and the municipalities. In case of conflicting parliamentary law at the federal level, tax treaties normally prevail over domestic law¹¹. This priority of two provisions of the same rank can be achieved by the interpretation rules of lex specialis derogate legi generali and lex generalis posterior non-derogat legi speciali priori. The tax treaty provision is seen as the more special provision.

However, due to the equality of status of treaty and federal domestic law, the prevailing opinion has been that the German legislature has the power to subsequently enact (later in time) rules that override the provisions in Germany’s existing tax treaties. Recently, Germany’s constitutional court¹² confirmed that the legislature could enact tax treaty override provisions that aim to secure Germany’s taxation rights, despite treaty provisions to the contrary.

In its decision, the constitutional court made a detailed analysis of the relationship between tax treaties and ordinary domestic law, and concluded that tax treaties do not rank superior to ordinary domestic law. For ordinary domestic law, however, the “lex posterior derogat legi priori” principle (a later law repeals the former law) applies, which means that the legislature can unilaterally introduce rules that deviate from earlier provisions in a tax treaty.

Canadian tax treaties require the tabling in Parliament of an implementing act to which the treaty is attached as a schedule, which makes the treaty prevalent over other laws to the extent of inconsistency; but only to reduce, not increase, the tax burden on the taxpayer. The only exception to that general rule is the Income Tax Conventions Interpretation Act (“ITCIA”) that is expressly intended to override Canada’s tax treaties¹³.

Italy’s tax code was recently amended to provide taxpayers with the right to choose and apply the most favorable and appropriate provisions included in either Italy’s tax code or treaty provisions, for each taxable transaction or item of income. That means no treaty override is possible.

The United Kingdom is the chief exponent of the dualistic approach. Concluding the treaty creates binding international law consequence, but it does not become part of domestic law until it is implemented through domestic legislation¹⁴. This constitutional approach is also found in Australia, New Zealand and South Africa among other countries¹⁵. Hence, treaty override provisions are easy to pass in the United Kingdom, unless such treaty has already been absorbed in the domestic law.

The Netherlands is an example of monist legal system. The monist view sees both international and domestic law as part of the same legal system. Article 93 of the Dutch Constitution provides that a treaty “shall become binding” upon publication if it is “binding on all persons by virtue of its contents”. It was the case, until recently, that the provisions of the treaty overrode domestic law (even if later in time) to the extent of inconsistency¹⁶. However, recently the Netherlands Supreme Court¹⁷ propounded that provisions of tax treaty allocate taxing rights and allow sufficient flexibility for the domestic law to determine when and how this taxation will occur.

Brazil does not allow treaty override provisions in the domestic law (either existing or subsequently enacted)¹⁸. Interestingly, the Superior Court¹⁹ opined that the provisions of International Tax Treaties prevail over domestic legislation, due to their specialty. This means that legislation enacted later in time and in a more specific fashion than the tax treaty could possibly override the tax treaties, under the lex specialis rule, thereby leading to treaty override and in essence breach of Art 98 of the Brazilian Tax Code.

To conclude, predominant interest of the other contracting state in a cross border transaction shall be to avoid double taxation of income, capital and estates by any modification to the domestic law.

Since tax treaties are like special legislation (leges speciales) compared to the contracting State’s general tax law (lex generalis), it shall be fairly concluded that “Lex specialis derogat legi generali” (“special legislation overrides general legislation”).

However, with the fiscal deficit going up, unilateral domestic tax laws amendments in contravention to the principles of international law for tax revenues has become the order of many developing countries. That too, when the legislation expressly or impliedly repeal the special law, then it is a violation of international law²⁰. Even any changes of domestic tax law normally will not affect existing treaties.

A solution to the domestic law override, shall be the involvement of the legislature in the negotiations, conclusion and implementation of treaties. If it overrides the treaty at a later stage after the treaty is in force, it is for the executive to resolve this conflict in some way or other, by renewed negotiations with the treaty partner.

 ¹8 I.L.M. 689, 1155 U.N.T.S. 332 (1969). Article 27 of the Vienna Convention reflects customary international law and is supported by the Committee on Fiscal Affairs of the OECD. See OECD Comm. on Fiscal Affairs, Report on Tax Treaty Overrides (1989).

²26 U.S.C. §7852(d)(1).

³ See, Tax Reform Act of 1986, Pub.  L. No. 99-514, § 1810(a)(4) (giving precedence to § 904(g)).

⁴Watt v. Alaska, 451 U.S. 259 (1981); Radzanower v. Touche, Ross & Co., 426 U.S. 148 (1976); United States v. United Cont'l Tuna Corp., 425 U.S. 164 (1976); Morton v. Mancari, 417 U.S. 535 (1974); Menominee Tribe of Indians v. United States, 391 U.S. 404 (1968); United States v. Payne, 264 U.S. 446 (1924).

⁵Posadas v Nat'l City Bank, 296 U.S. 497, 503 (1936).

⁶26 U.S.C. §894(a)(1), provides that“[t]he provisions of this title shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer.”

⁷See, Reuters Ltd. v. Tax Appeals Tribunal, 623 N.E.2d 1145 (N.Y. 1993)

⁸E.g. U.S. Model Income Tax Convention of September 20, 1996, at art. 2(1)(a), in Rhoades & Langer, op. cit., at 6:MOD-1, ß 1.02; U.S. Model Estate & Gift Tax Treaty of November 20, 1980, at art. 2(1)(a), in Rhoades & Langer, op. cit., at 6:MOD-5, ß 1.02.

⁹E.g. U.S. Model Income Tax Convention of September 20, 1996, at art. 24(6), in Rhoades & Langer, op. cit., at 6:MOD-1, ß 1.24; U.S. Model Estate & Gift Tax Treaty of November 20, 1980, at art. 10(4), in Rhoades & Langer, op. cit., at 6:MOD-5, ß 1.10.

¹⁰ The legislative procedure is regulated by Arts. 76-78 and 82 GG.

¹¹Schaumburg, Internationales Steurrecht, 2^nd ed., Köln (1998), marg. Note 3.26; also see, section 2 of GTC (Fiscal Code).

¹²Press Release No. 9/2016 of 12 February 2016 (also see, http://www.bundesverfassungsgericht.de/SharedDocs/Entscheidungen/DE/2015/12/ls20151215_2bvl000112.%20html%29

¹³The 2014 Federal Budget proposed that Canada implement a form of “treaty shopping” rule to deny treaty benefits in certain circumstances. However, the government has since indicated that it will await further work by the OECD on the BEPS project before implementing such a rule.

¹⁴Halsbury’s Laws of England, 5th edn (LexisNexis, 2014), Vol.20, Constitutional and Administrative Law, para.556

¹⁵Such as Austria, Denmark, Sweden, Ireland, Malta etc.

¹⁶Hoge Raad, 5 September 2003, no.37657, BNB 2003/380c.

¹⁷Hoge Raad, 23 May 2014, BNB 13/02237

¹⁸Art 98 of the Brazilian Tax Code

¹⁹Companhia Vale do Rio Doce vs. Federal Unionalso, Appeal 1,325.709 at Superior Tribunal de Justiça delivered on 24^th April 2014, (also referred to as the “Vale Case”)

²⁰OECD, Tax Treaty Override, 1989, No. 7. The report, adopted by the OECD Council on 2 October 1989, is reproduced as Chapter R(8) in Model Tax Convention on Income and on Capital, Vol. II, Paris: OECD, loose-leaf.