[Opinion] Interpreting Article 3(2) of Tax Treaties – Legal Interpretation

Subir Kumar & Niyanta Trivedi – [2025] 174 taxmann.com 1235 (Article)

1. Introduction

Many Sovereign States including India have entered into Double Taxation Avoidance Agreements (“DTAA”) to grant tax relief to ensure that a person is not subjected to pay tax twice on the income in two different countries. The DTAA does not contain any chargeability provisions but is subject to applicability of domestic tax laws in any international transaction to determine the income of a foreign assessee or adjudicate the issue of deduction required to be made by domestic entity while making payment to a foreign resident. Taxation laws have an interesting contradiction between sovereignty of a State to tax vis-à-vis interpretation of terms in a treaty. In this regard, under the international tax regime, one of the contentious issue is the applicability or non-applicability of Article 3(2) of various DTAAs in the domestic taxation laws at the time of determination of income that is liable to be taxed. This becomes highly important as there are conflicting views in relation to whether Article 3(2) should only be allowed to be read in the domestic laws when there is no definition of a term in a treaty or the domestic taxation statute/laws can also apply Article 3(2) of a treaty in situations where the legal terminology/jargons being subset of a definition is not defined.

The genesis or perhaps the need for DTAAs arose in the background of economic development and increase in cross-border transactions. The international community felt that it required a Model Convention that could potentially become Model Agreement for discussing or concluding Double Tax Avoidance Agreement. The history shows that after attempts made in the year 1928, 1943 and 1946, by different bodies, the Organisation for Economic Co-operation and Development (“OECD”). OECD set up a fiscal committee in 1956 and finally published 1992 Model Convention and Commentaries, last updated in 2014 and 2017. Parallely, UN published Model Tax Convention in 1980, giving more credence to right of the source State to tax international transaction. The OECD Model Convention encourages member countries to follow OECD convention while concluding or amending bilateral treaty. Article 3(2) of OECD and Article 3(2) of various DTAAs are often subject to various legal controversy owing to its applicability or non-applicability into domestic tax laws to adjudicate income under the domestic tax laws.

2. Legal Nature of Tax Treaties

Its now an accepted norm under international law that DTAA are agreements between two countries and hence, Vienna Convention on Law of Treaties (“VCLT”) applies to interpret any DTAA. However, it is also an accepted rule of law under international law that ambiguous terms in a treaty does require application of domestic laws to understand the contextual text and intention of two Contracting States. Both OECD and UN Model Tax Convention (“UNMC”) under Article 3(2) with slight modification in words adopts an ambulatory approach, which allows a Contracting State to look for meaning of a term under its laws in the event the said term is not defined under the bilateral treaty/DTAA. The problem however lies in restricting the scope of applicability of Article 3(2) only in cases where a term is not defined in a treaty as against allowing any Contracting State to look for meaning of non-defined terms in a definition of a term under treaty. In other words, the question is whether Article 3(2) prohibits the domestic tax authorities to apply its laws to understand non-defined subset terms in a definition in a treaty. Such problem could be seen in various DTAAs signed by India, where though the term is defined but the definition of a term itself refers to various legal terminology not defined in a term. Article 3(2) of OECD and UN Model Tax Convention imported into various DTAA, does to an extent overrides basic principle that “the treaty should prevail in the event of a conflict between the provisions of domestic laws and a treaty”. The only question is to what extent Article 3(2) of both conventions be allowed to apply the laws of charging Contracting State to understand the meaning of a non-defined terms in a definition.

3. The Ambit of Article 3(2) of OECD and UN Model Tax Conventions as Incorporated into Indian DTAAs

For the purpose of taxability, if the income is not taxed under domestic laws, reference to treaty provisions are not warranted. It is in cases when, income can be taxed under domestic laws but the provisions of a treaty are more beneficial to resident of another Contracting State, reference to DTAA are warranted. However, the issue of terms of treaty being more beneficial can only be put into perspective when the terms of treaty are unambiguous. In case of ambiguous terms of a treaty, it is rather difficult to apply the DTAA provisions. The DTAA’s itself provides for applicability of domestic laws. Article 3(2) is one such provision under these Conventions and DTAA’s that allows applicability of domestic laws unless the context otherwise requires to understand the meaning of a non-defined term in a treaty. To begin with many DTAA’s have similar definitions of a term as it has under the domestic laws of taxing State. The interesting question would then be about the non-defined terms/legal jargons in a defined term both under a treaty and domestic laws. How does one understand the meaning of such non-defined terms in a defined term. The answer is obvious that to understand the meaning of such terms, regard must be given to the context in which such words/terms are given either under the domestic laws or in a treaty. Though OECD and UN Conventions are on many occasions considered as source of interpretation of tax treaties, their legal status is questionable as far as non-members and its binding nature are concerned under the articles of the Vienna Convention. However, inspite of its status under Vienna Convention, the courts do give much credence to the commentaries of OECD and UNMC. In this context, the interpretation of Article 3(2) by courts assumes importance as the treaty itself provides for an internal rule of interpretation. As discussed above, Article 3(2) connotes following situations for internal rule of interpretation:

• Definition of the term in Treaty
• In absence of definition of term in Treaty, its meaning under the domestic laws
• Does the context of the Treaty require a meaning different from the domestic meaning?

A careful perusal of both the model convention elucidates the two fold parameters, first is the case of undefined term in a tax treaty which provides for resorting to domestic laws with ambulatory approach and second is the case wherein a contextual clarity is required to understand the intent of Contracting States. This would also include where definitions in the treaty contain terms that are not defined. It is pertinent to note that these conventions do not refer to VCLT as it lays down general rule of interpretation after analysing the international context in case of undefined terms.

The fact that such fiscal treaties have inherent provision of interpretation by way of Article 3(2) falls within the ambit of the international concept of Pacta Sunt Servanda laid out in Article 26 of VCLT9, which confirms the binding force of such treaty on the parties and ensures its compliance in good faith. Article 3(2) of the OECD & UNMC has been regarded as procedural laws by Klaus Vogel, and in his opinion- domestic law constitutes default law. He argues that those who want to deviate from domestic law and are in favour of contextual interpretation, the burden of proof lies on such deviating individuals.

In his book, Klaus Vogel has laid out the order of reference in interpreting terms of the treaty:

1. Application of Treaty definitions.
2. If no such special rules are applicable, the question to be asked is whether the law of the State applying the treaty (lex fori) attaches a special meaning to the term to the extent that it relates to the taxes covered by the treaty. The same question has to be asked if the treaty definition is not exhaustive or if the context requires not to apply the definition of term used in domestic law.
3. If the law of the State applying the treaty uses the term, the meaning of such term needs to be ascertained in order to ask whether the context suggests a different interpretation and, in the light of the weight to be given to alternative interpretations, whether the context requires a different interpretation.
4. If question (2) is answered in the negative, the general rules of interpretation should apply.

Thus, there is a clear understanding that when there are undefined/vague terms in treaty, then the first resort is to fall back on domestic law of the State under Article 3(2) provided it does not alter the context in which DTAA was signed.

On these lines various DTAAs has incorporated such framework which States that if a term in a treaty is not defined, then unless the context otherwise requires then Article 3(2) itself provides for applicability of domestic law for the purpose of understanding and interpreting a term which is not defined in a treaty.

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