This special feature focuses on the practice of tax treaty “shopping” and what is being done by national tax authorities and the Organisation for Economic Cooperation and Development (OECD) to crack down on this corporate tax avoidance practice.
Treaty shopping involves the improper use of a double tax agreement (DTA), whereby a person acts through an entity created in another state with the main or sole purpose of obtaining treaty benefits which would not be available directly to such a person.
For example, a company in a low tax jurisdiction plans to invest funds as a loan in the United Kingdom. The UK does not have a DTA with the country and therefore interest paid directly to the offshore company would ordinarily be subject to deduction of UK tax at source. To avoid this withholding tax, the company channels the funds through a company set up for this purpose in, say, Luxembourg. The Luxembourg company receives interest from the UK which it then pays on to the true source country. UK withholding tax on the interest is reduced to nil under the terms of the UK/Luxembourg DTA. Luxembourg does not levy withholding tax on interest paid on to the offshore country under its domestic law. If there were no provisions to counteract the effect of the arrangement, the offshore company would therefore benefit from the UK/Luxembourg DTA, though the income is subject to tax in Luxembourg only to an insignificant degree and not subject to tax at all in the UK.
Such arrangements could also be used where the beneficial owner is resident in a territory where the DTA retains a residual rate of withholding tax even after a clearance or claim for repayment of tax withheld; Australia or Canada, for example, where the territory of source retains 10% even after clearance.
Action 6 of the Organisation for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) Action Plan 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.
The OECD has previously examined the issue of treaty shopping. The concept of “beneficial owner” was introduced in the Model in 1977 in order to deal with simple treaty shopping situations where income is paid to an intermediary resident of a treaty country who is not treated as the owner of that income for tax purposes (such as an agent or nominee). At the same time, a short new section on “Improper Use of the Convention” (which included two examples of treaty shopping) was added to the Commentary on Art. 1 and the Committee indicated that it intended “to make an in-depth study of such problems and of other ways of dealing with them”.
In 2003, new paragraphs intended to clarify the meaning of “beneficial owner” in some conduit situations were added to the Commentary on Articles 10, 11 and 12 and the section on “Improper Use of the Convention” was substantially extended to include additional examples of anti-abuse rules, including a comprehensive limitation-on-benefits provision based on the provision found in the 1996 US Model as well as a purpose-based anti-abuse provision based on UK practice.
The OECD now 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 negotiating 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 provisions provided for by the US Model, and to a lesser extent, by some treaties concluded by Japan and India.
Based on the different approaches used by both OECD and non-OECD countries to tackle treaty shopping, it is recommended in the OECD’s Discussion Draft on BEPS Action 6, entitled “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances”, that the following “three-pronged” approach be used to address treaty shopping situations:
On April 11, 2014, the OECD published comments received from various stakeholders concerning its Discussion Draft on tackling treaty abuse.
In the main, many commentators warned that the proposals would likely be detrimental to the interests of multinationals and may hinder international trade.
"Our primary concern with the Discussion Draft is that its proposed rules to prevent the granting of tax treaty benefits in inappropriate circumstances will adversely affect the majority of taxpayers legitimately seeking treaty benefits for their genuine commercial and investment transactions”, Mary C Bennett of Baker & McKenzie stated.
"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 added.
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."
The Canadian Government is consulting on possible measures for the prevention of treaty shopping as part of a broader initiative to enhance the integrity of the tax system.
The consultation document, released in August 2013, contained seven questions for respondents to consider. They were as follows:
However, in January 2014, the Tax Executives Institute (TEI) expressed its regret that the Canadian Government has released draft legislation on so-called "treaty shopping" before the scope of the perceived treaty abuse problem has been quantified and disclosed.
In a letter to the Canadian Finance Minister, Joe Oliver, the TEI warns that "if access to treaty benefits is to be denied, the effort can only be effective if done in a manner that ensures certainty, fairness, and simplicity for taxpayers, and ease of administration for the Canada Revenue Agency (CRA)." To that end, the TEI suggests that Canada should adopt the approach of negotiating objective limitation of benefits clauses in particular treaties. It should do this in preference to "enacting a general and amorphous anti-treaty-abuse provision in its domestic legislation".
A further problem identified by the TEI relates to the practicality of determining whether "one of the main purposes" of a transaction is to obtain a treaty benefit. The TEI recommends that the intended "main purpose" approach be shelved, and an objective, specific test should be devised in its place. Were the main purpose test implemented, taxpayers and the CRA would need substantial guidance and examples to clarify its application, it said.
A rule to tackle treaty shopping was proposed in Canada’s 2014 budget. The rule would address arrangements identified as an improper use of Canada's tax treaties in the consultation paper. The rule would use a general approach focused on avoidance transactions and, in order to provide more certainty and predictability for taxpayers, building on comments received on the 2013 consultation paper, the rule would contain specific provisions setting out the ambit of its application. The approach would ensure that treaty benefits are provided with respect to ordinary commercial transactions and that, if the rule applies, the benefit that would be reasonable under the circumstances would be provided.
However, in response, the Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada urged the Government to align the proposed rule with current international developments, particularly the OECD’s initiative on BEPS.
While noting the exception provided in BEPS Action 6 on providing the grant of treaty benefits in appropriate circumstances, they commented: "The Proposed Rule does not contain a similar exception for non-abusive transactions and we strongly recommend that this exclusion be carefully re-considered having regard to the OECD discussion draft."
They also called upon the Department to provide further guidance on the more restrictive approach proposed. It stated: "Because the Proposed Rule takes a ‘general approach’ as opposed to a ‘specific approach,’ as described in Budget 2014, it is imperative that the Department provide as much guidance as to its possible application or non-application as possible."
"In particular, specific guidance in relation to what factors are relevant or determinative in different examples should be provided," it said.
On the proposed rule's bearing on the withholding tax regime, they said: "We suggest that payors of amounts to non-residents of Canada that are subject to Canadian withholding tax obligations should be provided with some form of protection from liability in circumstances in which treaty benefits are denied or reduced by reason of the Proposed Rule."
They noted also that: "It will not always be obvious to such payors that the Proposed Rule will be applicable in a particular set of circumstances, including in cases in which the payors’ actions are reasonable and prudent."
In July 2014, Australia launched a public consultation on its future tax treaty negotiation program, placing specific emphasis on these agreements' importance for the enforcement of the nation's transfer pricing rules to tackle international profit shifting.
Australia's 44 bilateral tax treaties generally follow the OECD Model Tax Convention on Income and on Capital, with some variations that are designed to protect Australia's domestic interests, for example provisions designed to protect Australia's taxing rights over the exploitation of Australian natural resources.
The Government is seeking feedback on the countries with which it may be desirable for Australia to renegotiate or update a tax treaty; and the key outcomes Australia should seek in negotiating tax treaties with other countries.
The Government noted that, not only do such agreements prevent the imposition of double tax on cross-border income, but they work to improve the integrity of the tax system by establishing a cooperation framework to collaborate with foreign authorities on the collection of outstanding tax debts, and provide for a mechanism to assist in tax dispute resolution.
The closing date for submissions is August 8, 2014.
The Indo-Mauritius tax treaty has been effective in India since April 1, 1983, and has been used since then for investment purposes, but since the year 2000 it has also become popular to use this structure to escape capital gains tax on stock exchange investments in India and this has particularly irked the Indian authorities.
Depending on the nature of the share-holding and the length of time it has been held, investors face capital gains tax of up to 20% in India. However, under the Indo-Mauritius tax treaty, capital gains accruing to a company resident in Mauritius are only taxable in Mauritius. As capital gains tax in Mauritius is 0%, and other taxes and fees are low, it becomes obvious why a large percentage of foreign investors into India choose to do so via a corporate structure involving a holding company registered in Mauritius.
In recent years, India has been successful in persuading a certain number of parties to its other tax treaties to insert limitation of benefits clauses into treaty texts to prevent such treaty abuse. However, direct talks with the representatives of the Mauritius government have so far proved fruitless.
While direct talks between the two governments have gone nowhere over the past decade or more, the Indian tax authorities have had limited success in challenging Mauritius-based structures established by foreign investors into India. Rulings issued over the past 12 years or so have tended to favor taxpayers by backing the terms of the treaty. Still, the situation is far from clear cut and court rulings on challenges by the Indian tax authorities to Mauritius-based structures established by foreign investors in India have tended to contradict one another.
A breakthrough may have occurred in June 2014 however, after the Mauritian Government proposed to the new Indian Government that it will approve a stringent limitation of benefits clause in a revised India-Mauritius double tax treaty, and will exchange information on persons applying to be registered in the territory with Indian authorities automatically.
Mauritian Prime Minister Navin Ramgoolam made the pledge during his visit to India to attend the swearing-in ceremony of India's 15th Prime Minister, Narendra Modi. He said: "There must be a quick resolution to resolve all issues related to the double tax avoidance agreement between the two countries."
In addition, Mauritius has pledged to vet companies registering in the territory to ensure that they meet well-defined criteria, in particular that they should be registering for a legitimate business purpose, and that there should be commercial value and economic substance linked to the choice of Mauritius as a business location.
In return, Ramgoolam said India should encourage businesses to use the financial sector of Mauritius by mobilizing funds on favorable terms and conditions for financing major infrastructural projects.
The OECD and certain jurisdictions seem determined to drive through changes to standard tax treaty wording that will reduce opportunities for tax treaty shopping and other treaty-related avoidance activities. However, as respondents to the various consultations released over the past year or so warn, this is not a matter that should be approached lightly by the authorities as change carries with it the considerable risk of disrupting global trade and investment flows. This is an issue therefore that taxpayers affected by potential changes should monitor closely.
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