The reality principle vs. internal fictions in the sphere of double tax treaties

The reality principle means that tax legislation is to be applied to ‘reality’. At first sight, a very straightforward principle. However, on an international level, the working of this principle is not as clear as day: does one refer to the economic or to the legal reality? And what about fictions within national law that distort (legal) reality and as a consequence make a State competent to levy taxes, which it would not be without such a domestic fictional provision? According to the prevailing view, such fictions should not be allowed to overrule the double tax treaties. This was recently confirmed by the Supreme Court of the United Kingdom.(1)

The judgment relates to the following facts. The taxpayer is a tax resident of South-Africa, but works as a salaried diver in the waters of the British continental shelf.

In principle, such a situation is covered by the article relating to employment income. In the case at hand, reference can be made to Article 14(1) of the United Kingdom - South-African Double Tax Treaty (hereinafter: “UK - SA Treaty”). This provision relates to income from employment and states as a general rule that this income is taxable only in the State of residence. Unless the employment is exercised in the other State, in which case that other State may levy taxes on it.

However, the United Kingdom (hereinafter: “UK”) introduced an internal fiction according to which divers in the waters of the British continental shelf are regarded as self-employed persons for the purposes of UK income tax. The main objective of this fiction was to allow them to apply the more generous expenses regime afforded to the self-employed (by comparison with employees), knowing that those divers commonly incurred their own costs.

As a - maybe unintended - consequence of this fiction, one could argue that Article 7 of the UK - SA Treaty must be applied. That provision, relating to business profits (cf. fictional self-employment) conferses the power to levy tax on profits exclusively on the State of residence, unless the activity is carried out in the other State through a permanent establishment. Since the diver is domiciled in South-Africa (and there is no permanent establishment in the UK), the application of the British internal fiction, in the opinion of the diver, leads to South-Africa being tax competent.

The case is brought before the Supreme Court of the United Kingdom, which mainly elaborates on two points.

Firstly, the Court focuses on the provisions of the UK - SA Treaty regarding the interpretation of certain terms. Article 3(2) of the UK - SA Treaty stipulates that terms which are not defined in the treaty shall be given the meaning that they have under the law of the State applying the relevant treaty, unless the context otherwise requires. In view of the absence of any definition of the term 'employment' in the UK - SA Treaty, it could be argued that the UK can indeed apply its domestic interpretation of this term. However, the OECD commentaries state that under domestic law, a contractual relationship can only be disregarded on the basis of objective criteria. Hence, not on the basis of the purely internal reclassification of the income type provided in favor of the taxpayer and (accordingly) only for tax purposes. This correlates with 1) the previously mentioned treaty exception: “unless the context otherwise requires” and 2) Article 31(1) of the Vienna Convention on the Law of Treaties which entails that the 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. Since the tax competency is allocated in a bilateral way, it would indeed in our opinion not make sense to allow a State to later - in a unilateral manner - change its domestic law (or add certain fictions) in order to interpret a legal term differently and so claim to be tax competent (2). Assigning a special meaning to a term can only be established if both the parties so intended (Article 31(4) Vienna Convention).

Secondly, the Court expressly based its solution on the reality principle. Nothing in the UK - SA Treaty requires Articles 7 and 14 to be applied to the fictional world that may be created by UK income tax rules. Rather, they should be applied to the real world. Any other interpretation would entail that Article 3(2) of the UK - SA Treaty offers States the possibility to unilaterally alter the meaning of undefined treaty terms by way of domestic fictions.

We conclude that the Court ruled that treaty provisions must be applied to the real world. By introducing a national fiction and applying it upon the treaty provisions by way of interpreting certain (undefined) terms, one is acting contrary to the bilateral international agreements. The judgment thus confirms that - even in a context where the fiction would work to the disadvantage of the State that introduced it - it cannot overrule the double tax treaty and have an effect on the allocation of taxing rights.

(1) UK Supreme Court, 20 mei 2020, Fowler v. Commissioners for Her Majesty's Revenue and Customs [2020] UKSC 22. (2) The same reasoning is applied by the Court in its decision that a State does not lose its tax competency merely because of a domestic fiction that allows a taxpayer to apply the tax rules for a certain (other) income type (and thus enables to apply the more generous expenses regime).