Why the Scope of ‘Taxes Covered’ Will Determine the Success of the UN Framework Convention’s Services Protocol

Early August, the eyes of the international tax world are once again focused on New York for the Fifth Session of negotiations of the UNFCITC.

The Fifth Session marks an important moment in the negotiations. Not only are the talks entering mid-point of a process that has started in January 2025 and that is expected to deliver final result by the end of 2027, it will also be the first session in which country delegates will be able to discuss a first full draft of the text of both the framework convention and its two early protocols, on dispute resolution and on cross-border services, respectively. 

The draft text of the services protocol was released late July. It gives us a first glimpse on the practical solutions countries are contemplating in the development of a protocol that is mandated to deal with the “taxation of income derived from the provision of cross-border services in an increasingly digitalized and globalized economy”. 

The Protocol draft is very much a zero draft, a preliminary piece that functions as a bridge between this workstream’s previous work on the topic and an actual draft of the final protocol. The most important conclusion is that this first draft draws heavily on the current bilateral tax treaty practice, and more specifically, the work on cross-border services carried on by the UN Tax Committee in its UN Model Double Taxation Convention. 

In that sense, the draft protocol looks a lot like a mini-tax treaty: it comes with all of a tax treaty’s standard provisions on scope, definition, dispute resolution and exchange of information, while adding novel distributional rules on cross-border services. These new rules, included in article 5 and 6 of the draft, grant new taxing rights to source countries where income from cross-border services (including automated digital services), is derived from. In light with previous discussions among delegates, novel nexus rules are introduced that determine the source country from which service income is derived. These nexus rules go beyond the UN Model’s focus on payor location, and grant source state taxing rights also in function of consumer location, performance location or user location. 

The draft protocol is designed like a self-standing mini-tax treaty because it will have to fix the cross-border taxation of services in two different scenarios. In the first scenario, the protocol will serve to override existing bilateral tax treaties and address the lack of source-state taxing rights over services income. In the second scenario, the protocol will apply in bilateral relations where no bilateral tax treaty is currently in place. In such cases, countries may be levying source taxation on services income based on whichever nexus deemed fit. What the protocol would add is an obligation for the residence state of the company to provide relief for double taxation, which is currently not always the case. 

The UNFCITC Service Protocol’s novel approach to ‘taxes covered’

While most of the secondary rules of the ‘mini-tax treaty’ look at lot like those in tax treaties and the UN Model, one provision of the draft protocol that is markedly different is article 2 on ‘taxes covered. 

Bilateral tax treaties have a formalistic approach to the scope of taxes covered: they apply to taxes on income – sometimes income and capital – but nothing more. 

The draft protocol’s provision on taxes embraces a different approach. Similar to bilateral tax treaties, Article 2 of the draft protocol provides that it applies to taxes on income from services, irrespective of the matter in which they are levied. The draft protocol then adds that this includes: “all taxes imposed on total income or on elements of income, including digital services taxes, equalization taxes related to services, excise taxes and other taxes imposed on behalf of a Contracting State having a similar economic effect with respect to income from services.” The draft provision also makes clear that VAT and other generally applicable consumption taxes are not within scope. 

The draft protocol’s provision on taxes embraces a different approach. Similar to bilateral tax treaties, Article 2 of the draft protocol provides that it applies to taxes on income from services, irrespective of the matter in which they are levied. The draft protocol then adds that this includes: “all taxes imposed on total income or on elements of income, including digital services taxes, equalization taxes related to services, excise taxes and other taxes imposed on behalf of a Contracting State having a similar economic effect with respect to income from services.” The draft provision also makes clear that VAT and other generally applicable consumption taxes are not within scope.

This addition is important. It reflects the workstream Lead’s view, as she expressed in previous negotiation sessions, that for the protocol to establish a comprehensive solution for the fair taxation of cross-border services, the new instrument cannot simply copy the formalistic approach to scope used in bilateral tax treaties. 

The reason is that the traditional treaty approach to scope has allowed countries dissatisfied with existing rules on services taxation to introduce new taxes on cross-border services that operate similarly to income taxes while formally falling outside the definition of an income tax.

Digital services taxes (DSTs) are a case in point. Instead of renegotiating tax treaties to better reflect a fair allocation of taxing rights in times of rising digitalization of the economy, countries have ‘legally engineered’ DSTs to do exactly what a limited gross tax on services under an updated tax treaty would do. 

Given that the purpose of the services protocol is exactly that – to renegotiate the rules the allocation of taxing rights on income from cross-border services – countries should accept that these newer and fairer allocation rules come with a restriction to the ability to legally engineer quasi-income taxes like DSTs. 

The recurring international stumbling block of scope 

The services protocol is not the first initiative of multilateral income tax rule coordination that is faced with the question of which taxes to cover. In both pillars of the OECD/G20 Two-Pillar Solution, the demarcation of what is covered as an income tax has been an issue.

For example, in the Global Minimum Tax (GloBE), under Pillar Two, it is essential for a tax paid in a country to be qualified as an income tax because only income taxes are taken into account to determine the local effective tax rate of multinationals and thus of any top-up tax liability. For this reason, the GloBE model rules contain criteria to distinguish ‘covered taxes’ from those that are not considered for minimum tax purposes. Under these rules, a withholding tax on outbound digital services within the income tax and covered by tax treaties would be a ‘covered tax’ whereas a DST, a tax that is economically similar to the gross income withholding tax, is not.

Similarly, the (mothballed) draft Amount A Multilateral Convention (MLC) under Pillar One, contains a complex set of rules on the ‘removal of existing measures’ to identify DSTs and other non-income tax measures that countries need to abolish to benefit from the new Amount A taxing right on cross-border income. The Amount A draft also contains an elaborate procedure to identify future digital services taxes and similar relevant measures that could be subject to removal. 

Taxes with a similar economic effect on all kinds of services 

One important thing the draft Amount A MLC got right is that the issue of taxes with similar economic effect as income taxes is not limited to digital services. DSTs may be the most recent and thought-provoking example of the practice, but other types of cross-border services have also been subject to legal engineering of quasi-income taxes. 

As mentioned by the Lead in past negotiations, the United States Federal Excise Tax on Foreign Insurance Premiums is nothing more than an equalization levy, imposed not on outbound fees for digital services like India used to do, but on insurance services. In a few of its bilateral income tax treaties, has even accepted adding this tax to the scope of taxes covered under those treaties. Remote gambling taxes/gaming duties, levied on an offshore gambling companies local share of gross revenue from gambling is another type of tax levied by the United Kingdom and a few other countries that awfully close to a gross withholding tax on income from gambling activities. 

The protocol’s draft article is rightly anticipating catching more taxes than just taxes with a similar effect as income taxes on not just digital services. 

Road ahead for the protocol and its article on scope

The topic of taxes covered under the protocol has previously been subject to controversy in the negotiations. Nearly all country delegates agreed that the protocol should not cover VAT and other general consumption taxes. All delegates also agreed that the protocol should cover income taxes in the strict sense. Far less agreement was found on the grey zone of taxes in between.

The draft provision on scope underscores the view that a comprehensive solution on fair taxation of cross-border services needs to go beyond covering income taxes. We believe this is the right approach, and countries are advised to endorse this approach in the upcoming session.  

This does not mean the work on this protocol article is complete. Currently, the draft article contains only an abstract definition of the quasi-income taxes it intends to cover, namely “taxes imposed on behalf of a Contracting State having a similar economic effect with respect to income from services”.  

To be applicable in practice, we believe that the article needs to be expanded on three points:

• The definition of measures with similar economic effect needs to be complemented with criteria that allow determining exactly whether a measure qualifies under the definition;
• A paragraph should be added on the identification of existing measures by protocol countries that are agreed to qualify under the definition; and
• A paragraph should be added with rules on the identification and consequences of identical or substantially similar measures that are imposed by protocol countries after the entry into force.  

The upcoming negotiations will in any case go a long way in revealing which way the wind is blowing on this topic among countries and whether they endorse the draft’s ambitious approach to ‘taxes covered’.