Allocation of Taxing Rights Regarding Derivatives: Domestic Law and Tax Treaties

Cross-border derivatives have been thriving. However, there is uncertainty regarding the allocation of the right to tax them on both the domestic law level and the tax treaty level. Currently, Germany, the United Kingdom and the United States do not levy source tax on cross-border derivatives. However, the United Kingdom and the United States may recognize interests from derivative payments and levy withholding tax; and the United States regards some dividend-equivalent payments as dividends for tax treatment, which bring the risks of qualification conflicts among tax treaties and thereby double taxation. Another potential qualification conflict arises from different criteria for business profits in different jurisdictions. Because most tax treaties provide little or no guidance on the treatment of derivatives, their income characterization often depends primarily on domestic law. Certain tax treaties even explicitly accept one of the contracting parties’ domestic rules for income characterization. In current tax treaty practice, alongside domestic law, both the treaty context and the specific characteristics of the derivatives themselves play a decisive role, suggesting an emerging expectation that the income characterization of derivatives may eventually become more harmonized under tax treaties.