STTR OECD

What are the implications of OECD's STTR on the business landscape?

The STTR allocates to the source country a limited and conditional taxing right to ensure a minimum level of taxation.


In brief

  • The STTR allows source countries to impose an additional tax liability on certain payments.
  • Multilateral Instrument will facilitate the implementation of STTR and is expected to open on 2 October 2023.
  • Alternatively, the STTR can be implemented into relevant tax treaties individually via bilateral negotiations.

Background

Among the series of documents that the Organisation for Economic Co-operation and Development (OECD)/G20 Inclusive Framework (IF) released on 17 July 2023 on the Base Erosion and Profit Shifting (BEPS) 2.0 project, is a document under Pillar 2 containing the model treaty provision of the Subject to Tax Rule (STTR), together with an accompanying commentary explaining the purpose and operation of the STTR. The STTR which is an integral part of Pillar 2 is a treaty-based rule that specifically targets risks to source jurisdictions posed by intragroup payments which take advantage of low nominal rates of taxation in the jurisdiction of the payee. 

STTR Design Elements

The STTR covers payments between "connected persons." The STTR includes a "targeted anti-avoidance rule (TAAR)" intended to prevent the use of intermediaries to avoid the STTR, such as interposing an unconnected person between two connected persons or routing a payment through a high-tax connected person.

The STTR applies to “Covered Income” such as interest, royalties, any income received in consideration for services etc. which is subject to a nominal tax rate of less than 9%. Nominal rate of tax will generally be the statutory tax rate applicable to the type of income. However, the nominal tax rate is lowered if the statutory rate is subject to a ‘preferential adjustment’. A preferential adjustment is a permanent reduction in the amount of the covered income subject to tax or the tax payable on that income in the form of a full or partial exemption or exclusion from income or a deduction from the tax base or a tax credit (excluding a credit for foreign taxes paid).

The STTR applies to Covered Income (other than interest and royalties) where the amount of Covered Income exceeds the costs incurred in earning that income plus a mark-up of 8.5%¹. The STTR applies if the aggregate sum of Covered Income paid in a fiscal year exceeds EUR 1 million (or EUR 250,000 for jurisdictions with GDP below EUR 40 billion). Taxes imposed under the STTR are levied after the end of the fiscal year in which they arise and not as a withholding tax. The recipient jurisdiction is neither required to exempt the Covered Income nor to provide a tax credit for tax payable under the STTR. A multilateral instrument will facilitate the implementation of the STTR. The same is expected to be open for signature from 2 Oct 2023 onwards. Alternatively, the STTR can be implemented into relevant tax treaties individually via bilateral negotiations. 

India Implications

India has extensive taxing rights under its domestic tax law on income arising to non-residents by virtue of concepts such as business connection/ significant economic presence (SEP) as a nexus for determining taxable presence. In addition, royalty, interest and technical service fees that arise in India to a non-resident is also taxed on a gross basis at 20%. Further, under India’s extensive tax treaty network, India has generally retained a right to tax royalty, interest and technical service fees on gross basis at 10%/ 15%. However, given the variations in the definition of technical service fees in tax treaties certain categories of technical service fees could fall outside the ambit of taxation in the absence of a permanent establishment (PE). Interpretative issues also arise on the definition of technical service fees on applicability to certain digital/ technology transactions. Transactions that do not involve “human intervention” or relate to the use of a “standard facility” maybe outside scope.

In this context, it would be useful to see the likely impact inclusion of STTR in India’s tax treaties could have on cross-border payments. A couple of illustrations would help understand this.

Example 1: A Ltd, a company resident in India, makes management service fees payment to a connected person (S Ltd), a company resident in State S. Under its domestic tax law India can tax the payment at 20%. However, under India-State S tax treaty, the fee is not taxable in India in the absence of a PE of S Ltd. While S Ltd is taxed in State S at a nominal tax rate of 17%, State S exempts income from taxation that is not received in State S. Since S Ltd receives this income in a bank account outside State S, the management service fee is not taxed in State S.
 

If STTR is included in India-State S tax treaty, the following could be the consequence: Management service fee paid to S Ltd is a covered income for purpose of STTR. The nominal rate of tax would be regarded as 0% since preferential adjustment applies. Hence, India would get a right to tax back up to 9% under STTR, subject to the monetary and mark-up thresholds being satisfied.
 

Example 2: I Co, a company resident in India and member of X Co group, functions as a re-seller of cloud computing services to customers in India. S Co, a company resident in State S and a member of X Co group, is a regional distributor of the services. I Co makes an arm’s length payment to S Co for cost of services purchased. S Co in-turn makes a tax-deductible payment of 95% of the consideration received from I Co to X Co, the group’s intangible property (IP) owner resident in State X, as consideration for obtaining regional distribution rights. S Co is taxed at 17% on its net income while X Co has a preferential regime under which it is taxed at 5% on IP income. Under the Indian domestic tax law S Co has a taxable nexus in India by virtue of SEP; but not taxable under India-State S tax treaty in the absence of a PE.
 

If STTR is included in India-State S tax treaty, the following could be the consequence: Income from cloud services could be covered income for purpose of STTR. The term “services” for purpose of STTR would generally be interpreted to mean an action performed for the benefit of another person. The method of delivery is not relevant to the determination. Even though S Co is taxed in State S at a nominal tax rate higher than 9%, the TAAR could potentially apply which allows the intermediary (S Co) to be disregarded in the transaction flow for determining the tax rate for purposes of STTR. The effect of the TAAR would be to treat the original payment by I Co to S Co as a payment of covered income to a connected person in State X and substitute the tax rate to which X Co is subject in State X in respect of the related payments from S Co, resulting in STTR applying.
 

If S Co is an e-commerce operator and subject to equalisation levy on the amount received from I Co, S Co could be exempt from income-tax by virtue of Section 10(50) of the Income-tax Act, 1961, regardless of STTR.
 

Concluding remarks
 

The STTR is a core element of Pillar 2 and, where applicable, the STTR would apply before the Global Minimum Tax Rules. While members of the IF have committed to implement the STTR into their bilateral treaties with members of the IF that are developing countries when requested to do so, the actual timeline for treaty changes to come into force remains uncertain. 

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    Summary 

    It is important for companies to evaluate the potential implications of the STTR for their businesses and monitor STTR developments in relevant jurisdictions.

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