This article explores the principles and provisions related to the taxation of capital gains as stated in Article 13 of the OECD Model Tax Convention. It examines the variations in capital gains taxation across countries and discusses the OECD Model Convention as a framework for negotiating bilateral tax treaties.
The article analyzes case laws, such as the ALTA Energy and Tradehold cases, to highlight the application and interpretation of Article 13. Furthermore, it examines the specific provisions on capital gains in tax treaties involving Turkey. The study provides insights into the allocation of taxing rights, the definition of capital gains, and the treatment of different types of assets. The analysis reveals similarities and differences between the OECD and UN Model Conventions and explores the taxation of capital gains in Turkey's double taxation agreements. Overall, this article contributes to a better understanding of the complex issues surrounding the taxation of capital gains in an international context.
The taxation of capital gains varies widely from country to country. Some countries do not tax capital gains at all, while others tax all or some capital gains. In some countries, capital gains are taxed as part of general income taxes, while in others they are taxed as a separate type of tax. Even within a single country, the taxation of capital gains may vary depending on the type of asset that is sold and the taxpayer's circumstances. For example, some countries may not tax capital gains on the sale of personal assets, while others may tax all capital gains regardless of the asset that is sold.
The OECD Model Tax Convention, developed by the Organization for Economic Cooperation and Development (OECD), is a comprehensive framework that serves as a guideline for countries when negotiating and drafting their bilateral tax treaties. The convention provides a standardized approach to the allocation of taxing rights between countries and helps in the prevention of double taxation and the resolution of tax disputes. It covers various aspects of international taxation, including the definition of permanent establishment, methods for the avoidance of double taxation, rules for the taxation of business profits, dividends, interest, royalties, and capital gains. In this article, we will discuss the principles of preventing double taxation related to capital gains as stated in Article 13 of the OECD Model Convention with case laws and analyze tax treaties of Turkey.
The Preliminary and Content of Article 13 of the OECD and Differences Between UN Model
The tax treatment of capital gains also differs across countries. Some countries tax capital gains as ordinary income, while others impose special taxes on specific types of gains, such as real estate or capital appreciation. The OECD Model Tax Convention does not explicitly address these issues, as it leaves the decision of how to tax capital gains up to each country's domestic law. Therefore, the Convention does not grant a country the right to tax capital gains if its domestic law does not provide for such taxation.
However, the Convention does apply to various types of taxes on capital gains and encompasses gains accrued both before and after the entry into force of a treaty. While the Convention does not provide an exhaustive solution to all aspects of capital gains taxation, it establishes a framework for countries to negotiate bilateral tax treaties that address this matter.
Article 13 of the OECD Model Double Tax Convention pertains to the taxation of capital gains. It provides guidelines for the allocation of taxing rights between the source country (where the property is located) and the resident country (where the taxpayer resides). The purpose of this article is to prevent the double taxation of capital gains, where the same income is taxed twice in both the source and residence countries.
As a general rule, capital gains are recognized only when securities or real estate assets are sold. However, in certain cases, revaluation differences related to these assets can also be considered as capital gains. This broadens the scope of capital gains to include situations where the value of an asset increases, even without a sale occurring. Article 13 is primarily designed to address cases where the asset being sold, which could result in capital gains, is fully owned by the person executing the sale. The distribution of capital appreciation gains, taking into account ownership shares, is determined according to the domestic legislation of the respective countries. This means that the rules regarding the division of capital gains among shareholders or co-owners will vary based on national laws. Certain states may view the transfer of an asset to a subsidiary or head office in another state as equivalent to disposing of the asset. In such cases, exit taxes may be applicable, imposing tax obligations on the transferring party. These taxes are intended to capture any potential capital gains that would have otherwise been realized through the transfer of the asset.
Merely attributing "economic ownership" of an asset to a business entity is insufficient to establish an effective relationship between the asset and the entity. Alongside economic ownership, the benefits, rights, and obligations associated with the asset must also be attributed to the same business entity. This requirement ensures that the entity is truly connected to the asset in terms of its benefits and responsibilities. The assets mentioned in the third paragraph of Article 13, such as aircraft and ships, pertain to the seller's own vehicles used in sales that could result in capital gains. However, for commercially operated aircraft and ships, the provisions of Article 7 are considered instead of Article 13. This distinction recognizes the unique nature of these assets and provides specific guidelines for their taxation within the double tax convention.
The UN and OECD Model Conventions both have provisions on capital gains, but there are some important differences between the two. For example, the OECD Model Convention grants the source country an unlimited taxing right on gains from the sale of shares in a company resident in the source country, while the UN Model Convention only grants the source country a limited taxing right on such gains.
Another difference between the two conventions is the way they define capital gains. The OECD Model Convention does not explicitly define capital gains, but the Commentaries accompanying the convention provide some guidance on the scope of this term. The UN Model Convention, on the other hand, does provide an explicit definition of capital gains, which includes gains made through various situations, such as the sale, transfer, or gift of ownership, as well as cases involving emigration or revaluations of book values.
The different paragraphs of Article 13 in both Model Conventions address specific types of capital gains. These include gains on immovable property, assets belonging to a permanent establishment, and ships, aircraft, and boats used in international or inland waterways transport. The allocation of taxing rights for these gains follows the same allocation rules as the income from these activities described in other articles.
In general, the UN and OECD Model Conventions allocate taxing rights on capital gains between the source country and the residence country. However, there are some cases where the residence country has the exclusive right to tax the gains. These gains are typically taxed on a net basis, which means that taxes are levied on the proceeds minus the purchase price or book value.
Enforcing taxation on capital gains can be challenging, especially when the buyer is a non-resident. In these cases, reporting requirements and withholding obligations may be difficult to enforce. However, if the buyer is a resident of the source country, it may be easier to gather information to ensure the enforcement of taxation on the seller.
Related Case Laws
ALTA Energy, a Luxembourg-based company, claimed an exemption from Canadian income tax for a capital gain resulting from the sale of shares of its Canadian subsidiary, ALTA Canada. The subsidiary was engaged in shale oil operations in the Duvernay formation in Northern Alberta. However, the Canadian tax authorities denied the exemption. The case revolved around the interpretation of Article 13(5) and Article 13(4) of the Canada-Luxembourg Income Tax Treaty. The tax authorities argued that the shares derived their value from ALTA Canada's Working Interest in the Duvernay Formation and should be taxed under Article 13(4). ALTA Energy contended that the Working Interest should be classified as Excluded Property. ALTA Energy appealed the decision, and the court allowed the appeal, referring the matter back to the tax authorities for reconsideration and reassessment. This decision was then appealed by the tax authorities before the Supreme Court. In 2021 The Supreme Court dismissed the appeal of the tax authorities but with dissenting judges.
Tradehold, an investment holding company incorporated in South Africa, owned a 100% shareholding in Tradegro Holdings, which in turn owned shares in Brown & Jackson plc, a UK-based company. In 2002, Tradehold relocated its effective management to Luxembourg while remaining a resident of South Africa. However, in February 2003, Tradehold ceased to be a resident of South Africa due to a change in the definition of "resident" in the relevant tax legislation. The South African Revenue Service argued that Tradehold should be subject to an "exit tax" on its deemed disposal of its shareholding in Tradegro Holdings. The Tax Court rejected this argument, stating that the reference to gains from the alienation of property in Article 13(4) of the double tax agreement (DTA) between South Africa and Luxembourg included both actual and deemed disposals. Therefore, starting from July 2002, Luxembourg had exclusive taxing rights over Tradehold's capital gains. The Court ruled in favor of Tradehold, finding that the Revenue Service had incorrectly included a taxable gain resulting from the deemed disposal in Tradehold's income for the relevant tax year.
Taxation of Capital Gains in Double Taxation Conventions of Turkey
In Turkey's local legislation, provisions regarding capital gains are included in Article 22, CIT and repeated Article 80, of the Income Tax Law. Article 22 of the CIT states that "In determining the profits of limited liability entities obtained through a place of business or permanent representative, unless otherwise specified, the provisions applicable to fully liable entities shall apply. (2) The provisions of the Income Tax Law regarding income and earnings other than commercial or agricultural profits of entities subject to limited liability shall apply. However, if these income and earnings are obtained within the scope of commercial or agricultural activities carried out in Turkey, corporate profits shall be determined in accordance with the first paragraph of this article." The Repeated Article 80 of the Income Tax Law specifies which gains arising from the disposal of goods and rights are considered capital gains. In the local legislation of Turkey, which addresses the taxation of capital gains, there are provisions in two separate tax laws. Furthermore, in the double taxation avoidance agreements that Turkey has signed, there are different approaches to the subject matter.
Article 13(1) of tax treaties to which Turkey is a party is generally in line with the OECD and UN Models. However, the US Agreement has a different provision that covers gains arising from the disposal of a partnership, foundation, or interest in an immovable property, limited to the amount attributable to a real estate asset. This provision also includes capital gains arising from the disposal of shares in Real Estate Investment Trusts.
Capital gains derived from the sale of real estate recorded in the assets of a commercial enterprise are also evaluated under this provision. For example, if an enterprise from State A sells a real estate located in State C that is registered in the permanent establishment of the enterprise in State B, Article 13(1) of the Agreement between State A and State B cannot be applied because the real estate's capital gains are not present in State B.
The Estonian and Lithuanian Agreements also include capital gains arising from the disposal of shares in real estate companies in Article 13(1). This means that Article 13(1) of the Estonian and Lithuanian Agreements covers the assets covered by Article 13(4) of the OECD Model, and evaluates both situations on the same basis.
Article 13(2) of tax treaties to which Turkey is a party states that gains arising from the disposal of movable assets belonging to a business establishment or movable assets pertaining to a fixed place of business used by a resident of one Contracting State for the exercise of independent professional activity in the other Contracting State may be taxed in the state where the business establishment or fixed place is located. This provision is compatible with the OECD and UN Models.
Turkish tax treaty law explicitly states that capital gains arising from the disposal of securities related to a fixed place used for the exercise of independent professional activity are covered by Article 13(2). This approach is consistent with Turkey's inclusion of Article 14, which regulates the taxation of independent professional activities, in newly concluded agreements, distinguishing it from the OECD Model.
The concept of a place of business or fixed place is not explicitly defined in tax treaties, but it can be understood to refer to a physical location where a business activity is carried out or an independent professional activity is performed. Gains arising from the partial or total disposal of a place of business or fixed place may be taxed in the countries where they are located.
In many of the tax treaties to which Turkey is a party, gains arising from the disposal of motor vehicles and related movable assets, which are not covered by Article 13(2) of the OECD and UN Models, are included within the scope of the article. This means that these gains can be taxed in the state where the business establishment or fixed place is located, even if they are not part of a place of business.
Only in the Agreements with Algeria, Indonesia, Estonia, Ethiopia, Morocco, South Africa, South Korea, India, Japan, Latvia, Lithuania, Malaysia, Egypt, Pakistan, Singapore, Thailand, and Tunisia, gains from the disposal of motor vehicles and related movable assets are not covered under Article 13(2) as in the OECD and UN Models. In these agreements, these gains are taxed in the state where the enterprise operating ships, aircraft, or motor vehicles is resident.
In all agreements to which Turkey is a party, capital gains derived within the framework of Article 13(3) shall be taxable only in the Contracting State of which allienator of ships/aircrafts is resident, as in the OECD and UN Models. However, in the agreements with the United Arab Emirates, Bulgaria, France, India, Iran, Northern Cyprus, Kuwait, Hungary, Macedonia, and Egypt, income derived is within the scope of the taxation authority of the state where the "legal center or registered office" is located, exclusively, rather than the state where the effective management center is located, as in the OECD and UN Models.
Only in the agreements with Bosnia and Herzegovina, Ethiopia, Morocco, and Saudi Arabia, income derived is subject to the taxation authority of the state where the effective management place or effective management center is located, exclusively, in line with the OECD Model.
In general, the tax treaties to which Turkey is a party do not have provisions that are parallel to Article 13(4) of the OECD Model, which deals with capital gains arising from the indirect sale of immovable property through the sale of shares or interests in a company that owns the property. Only the agreements with Australia, Finland (2009), and New Zealand are fully compatible with the OECD Model in this regard.
The France agreement regulates the gains arising from the disposal of shares in real estate companies by referring to the taxation regime in the source country. This means that the country in which immovable property is situated can tax the gains, even if alienated shares do not pertain to a company which is resident in the source country.
In the agreements with the People's Republic of China, Morocco, South Africa, India, Israel, and Egypt, although explicit provisions exist regarding the capital gains from the sale of shares in real estate companies, no threshold value is specified as in the OECD Model. This means that the source country can tax the gains regardless of the percentage of the shares that the taxpayer owns in the company.
The provisions equivalent to Article 13(5) of the OECD Model in the tax treaties to which Turkey is a party have been regulated in different ways.
In some of the treaties, the provisions equivalent to Article 13(5) of the Model Convention allow for the exclusive taxation of capital gains by the residence state. This means that the source state cannot tax capital gains that are not mentioned in Article 13. The agreements with Albania, Bangladesh, Bosnia and Herzegovina, Estonia, Morocco, the Philippines, Croatia, Israel, Kuwait, Latvia, Lithuania, Serbia and Montenegro, and Syria are fully compatible with the OECD Model in this regard.
In some other treaties, the provisions equivalent to Article 13(5) of the Model Convention allow for the joint taxation of capital gains by the residence state and the source state. This means that both states can tax capital gains that are not referred to in paragraphs 1, 2, 3 and 4 of the Article 13 , but the source state's right to tax is limited. The agreements with Bahrain, Brazil, Japan, Singapore, and New Zealand are examples of this type of provision.
In some of the treaties, there is a special provision regarding shares and bonds, where the capital gains arising from the disposal of shares or bonds within one year from the date of acquisition are also subject to taxation in the source state. This means that the source state can tax capital gains from the sale of shares or bonds, even if the residence state also has the right to tax the gains. The agreements with the United States, Australia, Belgium, the Czech Republic, Ethiopia, the Netherlands, Ireland, Spain, Italy, Norway, Russia, Slovenia, Ukraine, and Portugal are examples of this type of provision.
The taxation of capital gains varies significantly from country to country, and there is no standardized approach followed by all nations. The OECD Model Tax Convention serves as a framework to guide countries in negotiating and drafting their bilateral tax treaties, including provisions related to the taxation of capital gains. Article 13 of the OECD Model Convention focuses on preventing double taxation of capital gains and provides guidelines for the allocation of taxing rights between the source country and the residence country.
However, the interpretation and application of Article 13 may differ across different tax treaties and countries. Each country has the flexibility to design its domestic laws regarding the taxation of capital gains, and the specific provisions in tax treaties can further modify these rules.
Several case laws have shed light on the interpretation and application of Article 13 in different scenarios. For instance, the Alta Energy case in Canada-Luxembourg Income Tax Treaty dealt with the interpretation of Article 13(4) and 13(5) and resulted in a decision that referred the matter back to the tax authorities for reconsideration and reassessment. Similarly, the Tradehold case in South Africa-Luxembourg Double Tax Agreement clarified the exclusive taxing rights over capital gains and the inclusion of deemed disposals.
In the case of Turkey, the taxation of capital gains is governed by various tax treaties, and the provisions within these agreements may differ from the OECD and UN Models. Turkey has entered into agreements with different countries, each having its specific provisions related to the taxation of capital gains. These provisions address gains arising from the disposal of real estate, movable assets, shares in real estate companies, and other types of assets.
It is important for taxpayers and tax professionals to carefully review the relevant tax treaties and understand the specific provisions governing the taxation of capital gains. The variations in tax treaties highlight the significance of seeking professional advice and understanding the tax implications in each specific case.
Overall, the taxation of capital gains is a complex and evolving area of international tax law, and it requires a thorough understanding of domestic laws and relevant tax treaties to ensure compliance and minimize the risk of double taxation.
By Onur Cagdas Ozgur, Tax Senior Manager, Nazali Tax & Legal