September 23, 2014
Last week, the Organisation for Economic Cooperation and Developments (OECD) released its first batch of “deliverables” as part of its ambitious plan to limit opportunities for multinational businesses to indulge in base erosion and profit shifting (BEPS) activities to mitigate tax paid in the jurisdictions in which they operate. Included among the package of reports was a series of recommendations on Action 6: Preventing Tax Treaty Abuse, which is explored in this feature.
In February 2013, the OECD released its preliminary BEPS report “Addressing Base Erosion and Profit Shifting” on the use of tax-efficient business structuring by multinationals to lower group corporate tax liability, as a first step to addressing the use of profit-shifting tax planning techniques by international businesses.
Then, on July 19, 2013, the OECD released its much anticipated BEPS Action Plan, which it claims provides “a global roadmap that will allow governments to collect the tax revenue they need to serve their citizens” while giving “businesses the certainty they need to invest and grow.”
Introduced at the G20 Finance Ministers’ meeting in Moscow last year, the Action Plan identifies 15 specific actions that will give governments the domestic and international instruments to prevent corporations from paying little or no taxes.
Action 6 proposes the development of model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in “inappropriate circumstances.” Work will also be done, it says, to clarify that tax treaties are not intended to be used to generate double non-taxation. Additionally, tax policy considerations will be identified that countries will be urged to examine before deciding to enter into a tax treaty with another country. These three areas were the main focus of the OECD’s 31-page Discussion Draft on Action 6, published on March 14, 2014 (see below).
Another key element of this Action will be modifications to the definition of permanent establishment (PE) which the report says “must be updated to prevent abuses.” However, tax treaty measures to prevent the artificial avoidance of PE status (Action 7) are not due to be released until September 2015, and are therefore not dealt with here.
The Draft discusses scenarios potentially involving treaty abuse, in particular involving the use of treaties to circumvent tax on dividends, and otherwise artificially re-route payments to achieve a tax advantage. A distinction is proposed, in these examples, between what should be considered to be abusive and non-abusive transactions.
The OECD proposes to modify the preamble to the OECD Model Tax Convention, to highlight the need to negotiate treaties without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance. It would include wording warning against the negotiation of treaties that enable treaty shopping through the provision of benefits to residents of third states. Further to this, the OECD proposes to generalize the limitation-on-benefits (LOB) provisions provided for by the US Model, and to a lesser extent, by some treaties concluded by Japan and India.
The discussion draft includes an idea for a tax treaty general anti-avoidance rule, or purpose test.
Many of the respondents’ concerns are centred on the fact that the new measures, if put in place, would seriously reduce the ability of cross-border investors to claim legitimate treaty benefits, which in turn could have a negative impact on the global economy by reducing international trade and investment.
Comments by Mary C Bennett of Baker & McKenzie LLP, Counsel to the Association of Global Custodians, on the proposals outlined in the Discussion Draft were fairly typical of the many responses received by the OECD on this issue.
"We are concerned that the proposals will lead to uncertainty and [a] lack of clarity, thereby disrupting the process for obtaining legitimate treaty relief for high volume cross-border investment flows and undermining the very purpose of treaties," she said.
In a separate response, Will Morris of the Business and Industry Advisory Committee (BIAC) to the OECD warned that: "Restricting the application of treaty protection should be approached with considerable caution lest it result in a heavy cost for international trade and be contrary to the aims of the OECD." He emphasized that: "Such restriction should only occur in clear cases of abuse."
Subsequent to the publication of the Discussion Draft on Action 6, the OECD attracted criticism for completely overlooking the negative impact these proposals could have on the funds industry, with collective investment schemes likely to experience great difficulties in claiming treaty benefits.
The LOB article promoted by the OECD (explained in more detail below) broadly requires a fund that wishes to claim treaty benefits to have a significant connection with the country in which it is resident for tax purposes, be it an effective listing or a majority of investors there. However, as the Alternative Investment Fund Managers Association (AIMA) pointed out in an email to the UK Treasury warning of the ramifications of the BEP initiative on the UK funds sector: “Many funds are not listed and pool capital from investors across a number of countries and so will not pass the limitation of benefits threshold. Further, the impetus of EU regulatory regimes such as the UCITS Directive is that funds should through “passporting” be readily marketed outside their home jurisdiction.”
“The measures will therefore affect not only funds that are domiciled in the UK which will become unable to benefit under double tax treaties to the present extent but also the fund management industry in the UK which is able to establish and promote investment funds that offer the advantages of collective investment to institutional investors in particular across a number of jurisdictions,” the AIMA communication, published by the association on April 8, went on to note.
With much fanfare, the OECD released its first set of “deliverables” on September 16, 2014, marking the half-way stage of the project.
The 2014 BEPS package consists of two final reports (Action 1 and Action 15), one interim report (Action 5) and four reports containing draft recommendations (Actions 2, 6, 8 and 13) which are agreed and will be finalized with further work on implementation and interaction with the 2015 deliverables.
This first set of recommendations represent, according to the OECD, "a co-ordinated international response to base erosion and profit shifting”. In terms of the Action 6 recommendations, there are no surprises however; the proposals contained in the report “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances” basically parrot those published in the earlier Discussion Draft.
In essence, the main focus of the new report is the adoption by countries of measures to prevent treaty shopping, and, as the report’s title suggests, the granting of treaty benefits in “inappropriate circumstances”.
With regards to treaty shopping, the report recommends a three-pronged approach to combat the use of such arrangements:
These recommendations reflect the fact that no agreement on a single course of action could be reached when the proposals were being formulated by the OECD, hence the report recommends that countries may adopt either approach or a combination of the two, depending on how compatible they are with domestic laws and other country-specific factors.
The report itself recognises that these rules may require adaptations, for example to take account of constitutional or EU law restrictions, and allows some flexibility in implementing the recommendations.
However, the report says that “at a minimum” countries should agree to include in their tax treaties an express statement that their common intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements.
The LOB rule included in the report restricts the general scope of the treaty rule according to which a treaty applies to persons who are residents of a Contracting State. Paragraph 1 of the LOB rule provides that a resident of a Contracting State shall not be entitled to the benefits of the Model Tax Convention unless it constitutes a “qualified person” under paragraph 2 or unless benefits are granted under the provisions of paragraphs 3, 4 or 5. Paragraph 2 determines who constitutes a “qualified person” by reference to the nature or attributes of various categories of persons; any person to which that paragraph applies is entitled to all the benefits of the Convention. Under paragraph 3, a person is entitled to the benefits of the Convention with respect to an item of income even if it does not constitute a “qualified person” under paragraph 2 as long as that item of income is derived in connection with the active conduct of a trade or business in that person’s State of residence (subject to certain exceptions). Paragraph 4 is a “derivative benefits” provision that allows certain entities owned by residents of other States to obtain treaty benefits that these residents would have obtained if they had invested directly. Paragraph 5 allows the competent authority of a Contracting State to grant treaty benefits where the other provisions of the LOB rule would otherwise deny these benefits. Paragraph 6 includes a number of definitions that apply for the purposes of the Article. A detailed Commentary explains the various provisions of the LOB rule.
The PPT rule included in the report incorporates principles already recognised in the Commentary on Article 1 of the Model Tax Convention. It provides a more general way to address treaty abuse cases, including treaty shopping situations that would not be covered by the LOB rule (such as certain conduit financing arrangements). That rule reads as follows:
Notwithstanding the other provisions of this Convention, a benefit under this Convention shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of this Convention.
That rule is accompanied by a Commentary and examples that explain and illustrate its application.
The report includes additional recommendations for new specific treaty anti-abuse rules that seek to address strategies, other than treaty shopping, aimed at satisfying treaty requirements with a view to obtain inappropriately the benefit of certain provisions of tax treaties.
These targeted rules, which are supplemented by the PPT rule described above, address:
Acknowledging that treaty anti-abuse rules are unlikely to be enough on their own to address tax avoidance strategies that seek to circumvent domestic tax laws, the report suggests that these must be addressed through domestic anti-abuse rules, including through rules that may result from the work on other aspects of the Action Plan.
The report indicates that further work may be needed to take account of recommendations for the design of new domestic rules that may result from the work on various Action items, in particular Action 2 (Neutralise the effects of hybrid mismatch arrangements), Action 3 (Strengthen CFC rules), Action 4 (Limit base erosion via interest deductions and other financial payments) and Actions 8, 9 and 10 dealing with Transfer Pricing.
Additionally, the recommends that the principle that treaties do not restrict a State’s right to tax its own residents (subject to certain exceptions) should be expressly recognized through the addition of a new treaty provision based on the so-called “saving clause” already found in United States tax treaties.
The report also recommends that certain parts of the Commentary within the Model Tax Convention will need altering, including in the following areas:
Section B of the report clarifies the principle that tax treaties are not to be used to generate double non-taxation. This clarification is provided through a reformulation of the title and preamble of the Model Tax Convention that will clearly state that the joint intention of the parties to a tax treaty is to eliminate double taxation without creating opportunities for tax evasion and avoidance.
Section C of the report deals with tax policy considerations that countries should consider before deciding to enter into a tax treaty with another country. The policy considerations described are designed to help countries explain their decisions not to enter into tax treaties with certain low or no-tax jurisdictions. They will also be relevant for countries that need to consider whether they should modify (or, ultimately, terminate) a treaty previously concluded in the event that a change of circumstances (such as changes to the domestic law of a treaty partner) raises BEPS concerns related to that treaty.
Unlike the initial Discussion Draft on Action 6, the new report recognises that further work is needed with respect to the implementation of the minimum standard and with respect to the policy considerations relevant to treaty entitlement of collective investment vehicles (CIVs) and non-CIV funds. According to the explanatory statement accompanying the new reports, policy considerations will be addressed to make sure that these rules do not unduly impact funds “in cases where countries do not intend to deprive them of treaty benefits”.
The work on model treaty provisions and relevant Commentary with respect to the policy considerations relevant to treaty entitlement of CIVs and non-CIVs funds will be finalised by September 2015.
This first set of deliverables will be presented to G20 Finance Ministers in September 2014 and Leaders in November 2014, following which a mandate will be drafted to be considered by the OECD Committee on Fiscal Affairs in January 2015 for the negotiation of a multilateral convention to streamline the implementation of the BEPS Action Plan.
The 15 BEPS Action Plan deliverables span three different areas: best practices and model domestic rules with respect to domestic law measures, changes to the OECD Model Tax Convention and internationally agreed guidance on implementation (such as the Commentary to the OECD Model Tax Convention and the Transfer Pricing Guidelines), and other reports.
Once finalised, these measures are expected to become applicable via changes to bilateral tax treaties or through the multilateral instrument, through changes in domestic laws and with support from internationally agreed guidance.
Some form of multilateral instrument is thought vital to prevent the renegotiation of thousands of bilateral tax treaties, which would be highly impractical, if not impossible.
The OECD has been praised for its tenacity in taking on the BEPS project, for managing to a secure a broad consensus across countries in support of its goals and for largely sticking to its self-imposed short timetable, which is highly ambitious to say the least. And in one sense at least, businesses and tax experts have expressed relief that the OECD and the G20 are actually tackling the issue of corporate tax avoidance rather than just talking about it and keeping investors guessing.
Francesca Lagerberg, global leader for tax services at accounting firm Grant Thornton, said following the deliverables release that her firm was “fully supportive of the work being undertaken by the OECD, which should go some way to allaying business concerns by moving this debate away from talk to action.”
“The existing legislation is no longer fit for purpose in an increasingly interconnected, digital world in which the definition of a 'border' is archaic and next to meaningless," she added.
However it is the sheer scale of the initiative that is its largest flaw, and others argue that the BEPS project is making the future look more uncertain rather than less.The package of reports released on September 14 contained only limited recommendations, and there are lots of loose ends which depend on how the rest of the deliverables shape up next year, whilst allowances are also made to deal with country-specific circumstances.
In terms of its work on anti-tax treaty abuse, the OECD has already acknowledged that its proposals have the potential to cause “collateral damage” by inhibiting legitimate cross-border transactions and capital market operations if not implemented carefully and uniformly.
However, the damage might already have been done. Investors and businesses hate uncertainty and all the OECD seems to have done with its first set of deliverables is fuel it. In such a changeable environment they are more likely to sit on the sidelines and wait for clarity.
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