INTERNATIONAL TAXATION • TREATY INTERPRETATION The Chartered Accountant • January 2023 • Vol. 71 • pp. 65–70 (Journal pp. 777–782)

Apposite of Article 3(2) of OECD model tax convention

AR
CA. Amit Rustagi
Member of the Institute • Contact: eboard@icai.in

Historical Genesis & Legislative Intent of Article 3(2)

Organisation for Economic Co-operation and Development (OECD) commentary on the Article 3(2) provision and its history is very illuminating. Language similar to Article 3(2) first appeared in U.S. Treasury Regulations issued in 1940, and its first operational appearance in a bilateral tax treaty occurred in the landmark US–UK Double Tax Treaty of 1945.

Paragraph 2 of Article 3 of the OECD Model Convention, 2017 provides that, for the convention, any terms that are not defined in it have the meaning it had at that time under that state’s law unless the context requires otherwise. Paragraph 2 of Article 3 of the OECD MTC, therefore, provides leverage to domestic legislation, but is conditioned on the context.

1. Article 3(2) of OECD MTC: Verbatim Extract from OECD MTC, 2017

“As regards the application of the Convention at any time by a Contracting State, any term not defined therein shall, unless the context otherwise requires or the competent authorities agree to a different meaning pursuant to the provisions of Article 25, have the meaning that it has at that time under the law of that State for the purposes of the taxes to which the Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State.”

2. Undefined Treaty Terms: The Six Core Interpretive Conundrums

Judicial interpretation of tax treaties (Robert Thornton Smith, p. 878) encounters six pivotal questions regarding undefined terms under Article 3(2):

Question 1: Nature of Undefined Terms

Does the reference to undefined terms refer only to single words, or does it extend to clauses, expressions, and legal concepts?

Question 2: Identity vs. Similarity of Terms

Does the provision direct reference only to internal tax law terms that are strictly identical, or does it permit reference to analogous or similar terms?

Question 3: Internal Concepts in Treaty Definitions

Does this clause direct the use of internal law concepts to provide meaning to undefined terms that are used within treaty definitions themselves?

Question 4: Standard for Contextual Requirement

When does the treaty’s context “require” the use of a contextually derived meaning rather than a reference to internal tax law?

Question 5: Temporal Meaning (Static vs. Ambulatory)

When internal law concepts are appropriately used, is it the law at the time the treaty was concluded, or does it incorporate post-execution amendments?

Question 6: Jurisdictional Choice of Internal Law

Whose internal tax law definition should be used—the law of the State of residence or the law of the State of source?

3. Relevance & Classification of “Context”

The term “context” as used in Article 3(2) of the OECD MTC has a broader meaning than the context mentioned in Article 31(1) of the Vienna Convention on the Law of Treaties (VCLT).

Two-Step Analytical Protocol under OECD Commentary (Para 12):

Step 1: If the term has been defined in the DTAA itself, that treaty definition must be followed exclusively.
Step 2: If the term is NOT defined in the DTAA, the interpreter must first look at the context. The context is determined based on the intention of the contracting states while signing the convention.
Reference to domestic law is required unless the context requires otherwise; where the context requires otherwise, we follow the context as per the VCLT. Domestic law definitions apply only when context does not mandate an alternate interpretation.

The Three Tiers of Context under International Law:

Type of Context VCLT Article Scope & Practical Coverage
The Intrinsic Context Article 31(2) Covers all textual elements inextricably linked to the treaty, including treaty text, preamble, annexures, protocols, subsequent agreements concluded by the contracting states, and materials prepared in connection with the convention.
The Primary Extrinsic Context Article 31(3) Evidenced in mutual agreement procedures (MAP), subsequent administrative practices followed by the states in connection to the treaty, and similar treaties (covering other tax and non-tax treaties).
The Secondary Extrinsic Context Article 32 The broadest of the three tiers: includes third-state court rulings, Model Convention Commentaries, travaux préparatoires (preparatory works), unilateral statements of intent, and all surrounding facts and circumstances at the signing of the treaty.

4. Special Rule vs. General Rule: Article 3(2) vs. VCLT Articles 31 & 32

A fundamental jurisprudential debate centers on the hierarchy between the lex specialis of Article 3(2) and the customary international law codified in the VCLT:

Special Rule Priority Subject to General Rule:

As a special rule of interpretation, Article 3(2) of OECD MTC may have priority over the general rule. However, the words used within Article 3(2) itself must be interpreted in accordance with the principles set out in Article 31 of the VCLT. Thus, the special rule remains structurally subordinate to the general rule of good faith and the object and purpose of the treaty.

Mandatory Character of “Shall” vs. Permissive “May”:

Throughout the OECD MTC, the words ‘shall’ and ‘may’ are used deliberately to distinguish mandatory duties from permissive authorities. The use of the word ‘shall’ in Article 3(2) establishes a mandatory requirement to apply domestic law in the case of undefined terms unless the context otherwise requires.

Threshold for Contextual Departure (Klaus Vogel Standard):

The word “required” in the qualifying clause ‘unless the context otherwise requires’ sets a strict evidentiary bar: “all possibly reasonable interpretations from the context should not give rise to a deviation from the rule of Article 3(2) of OECD MTC but only those backed by particularly robust arguments.” (Professor Klaus Vogel, 1983).

5. Interplay with India’s Income-tax Act, 1961 (Section 90 Dynamics)

5.1. Salient Features in OECD Commentary on Article 3(2):

Article / Provision Para OECD Statutory Explanation
Article 3(2) Para 13.1 Where there is both a tax definition and a non-tax definition of that term in multiple branches of domestic law, the tax definition will be preferred.
Article 3(2) Para 13.2 If an agreement has been reached by the competent authority under Article 25 (MAP) regarding the meaning of the term, then the domestic law meaning shall not apply.
Introduction of OECD MTC Para 35 An ambulatory (dynamic) approach to the interpretation of undefined terms will apply, incorporating post-treaty domestic amendments.

5.2. Approaches in Interpretation: Static vs. Ambulatory (Dynamic)

When domestic law changes subsequent to treaty signing, two competing interpretive doctrines emerge:

(a) Static Interpretation:
Assigns the meaning prevailing in domestic law on the date the treaty was concluded/signed. Freezes definitions in time.
(b) Ambulatory (Dynamic) Interpretation:
Assigns the meaning prevailing in domestic law on the date of treaty application. Explicitly endorsed by OECD Commentary where context does not require otherwise.
Limit on Ambulatory Approach: The ambulatory approach cannot be applied when an underlying domestic amendment alters the fundamental sum and substance of the term, as this would allow a contracting state to unilaterally override the DTAA. Disagreements require Mutual Agreement Procedure (MAP).

5.3. Indian Statutory Mechanisms: Section 90(3) and Explanations 3 & 4

Section 90(3): Mandates that any term used but not defined in the Act or in the DTAA shall have the meaning assigned to it in notifications issued by the Central Government, provided it is consistent with the context and the DTAA.
Explanation 3 to Section 90: Clarifies that terms notified by Government notification take effect retrospectively from the date on which the relevant DTAA entered into force.
Treaty Conflict Note: Tax treaties signed by India with countries such as Armenia, Sudan, Hungary, Kazakhstan, Portugal, and South Africa specifically prescribe the ambulatory approach (terms defined by domestic law prevalent at the relevant time). Hence, domestic retrospective amendments under Section 90(3) can conflict with bilateral treaty text!
Explanation 4 to Section 90: Clarifies that:
  • Where a term is defined in the DTAA, the treaty definition strictly controls; and
  • Where a term is not defined in the DTAA but defined in the Act, the domestic definition and administrative explanations apply.

5.4. International Context vs. Domestic Definition

Where a term in a DTAA conflicts with domestic legal systems, its meaning must be ascertained with reference to its international fiscal meaning rather than a parochial meaning peculiar to one state’s domestic law, preserving mutual consensus between contracting parties.

6. The Great Jurisdictional Debate: Whose Internal Law Applies?

The statutory phrase “application of the Convention” creates an intense scholarly controversy: Does Article 3(2) refer to the internal tax law of the Source State or the Residence State?

Particulars Source State Stance Residence State Stance
Leading Scholars John Avery Jones Professor Klaus Vogel & Dr. Rainer G. Prokisch
Core Contention Only the source jurisdiction is actively “applying” the distributive rule; the residence jurisdiction merely applies Article 23 relief provisions “as it affects itself”. Residence jurisdiction must itself apply treaty provisions to determine whether the source jurisdiction’s taxation was truly “in accordance with” the DTAA.
1. Purposive View Favoring Source State:

Limits the Residence State’s Article 23 inquiry strictly to verifying whether the source jurisdiction had the primary right to tax.

2. Purposive View Favoring Residence State:

Permits the residence jurisdiction to independently characterize income to preserve its own sovereign understanding of the DTAA.

Judicial Precedent (Boulez v. Commissioner, 83 T.C. 584 [1984]): The US Tax Court held that there is no reasoned basis for favoring the source jurisdiction’s characterization at the expense of the residence jurisdiction’s characterization. Article 3(2) cannot arbitrate bilateral divergences. Resolution requires recourse to Article 25(3) MAP or the customary interpretation rules of Article 31 VCLT.

7. Hierarchy of Literature & Extrinsic Aids in Treaty Interpretation

7.1. Primary Aids: Vienna Convention on the Law of Treaties (VCLT, 1969)

  • Article 31 VCLT: General rule of interpretation (good faith, ordinary meaning in context, object and purpose).
  • Article 32 VCLT: Supplementary means of interpretation (preparatory works, circumstances of conclusion).
  • Article 33 VCLT: Interpretation of treaties authenticated in two or more official languages.

7.2. Secondary Extrinsic Aids: Evidentiary Status & Legal Weight

No. Extrinsic Material Legal Status, Evidentiary Weight & Judicial References
8.2.1 OECD Model Commentary Neither binding nor has force of law; falls under Article 32 VCLT supplementary means; highly persuasive.
8.2.2 Treaty Protocol Integral part of the tax treaty with identical binding force as the main clauses (Sumitomo Corporation vs. DCIT [2017] 110 TTJ 302 [Delhi]).
8.2.3 International Articles & Expert Opinions Valuable material for interpretation; purely persuasive (ITC Ltd. vs. DCIT [2003] 85 ITD 162 [Kol.]).
8.2.4 Treaty Preamble Guides interpretation of object and purpose under Article 31(2) intrinsic context.
8.2.5 Parallel Treaties Aids to interpretation; evidentiary value generally subordinate (Raymond Ltd. vs. DCIT 80 TTJ 120 [Mum.]).
8.2.6 Unilateral Explanatory Memoranda Does not satisfy Article 31(2)(b) VCLT; falls outside treaty context and Article 32 accompanying materials.
8.2.7 Domestic Law Definition Invoked via Article 3(2) where term is undefined and context does not require an alternate meaning.
8.2.8 Foreign Court Rulings Persuasive; evaluated in the context of treaty object and purpose, mutual state consensus, and judicial hierarchy.
Comprehensive Judicial & Academic References:
  1. T.D. 4975, 1940-2 C.B. 43, 52 (US Treasury Regulations, 1940).
  2. John F. Avery Jones, The Interpretation of Tax Treaties with Particular Reference to Article 3(2) of the OECD Model, supra note 18, at 18n. 14.
  3. Robert Thornton Smith, Tax Treaty Interpretation by the Judiciary, 35 Tax Lawyer 878.
  4. Professor Klaus Vogel, Double Taxation Conventions, 17(1983) (introduction); supra note 13, at 139–142.
  5. John F. Avery Jones, United Kingdom: The Interpretation of Tax Treaties, supra note 189, at 609.
  6. Klaus Vogel & Rainer G. Prokisch, Interpretation of Double Taxation Conventions, IFA Cahiers de Droit Fiscal International, Vol. 78a (1993), at 77–79.
  7. Pierre Boulez v. Commissioner, 83 T.C. 584 (1984) (US Tax Court).
  8. Kees van Raad, OECD Commentary on Scope of Article 25 (Mutual Agreement Procedure), Materials on International & EC Tax Law (2016/17), p. 537.
  9. Sumitomo Corporation vs. DCIT (2017) 110 TTJ 302 (ITAT Delhi).
  10. ITC Ltd. vs. DCIT (2003) 85 ITD 162 (ITAT Kolkata).
  11. Raymond Ltd. vs. DCIT (2003) 80 TTJ 120 (ITAT Mumbai).