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In 2013, the Organisation for Economic Co-operation and Development (OECD) and G-20 countries adopted a 15-point Action Plan on Base Erosion and Profit Shifting (BEPS). The action plan aims to ensure that profits are taxed where the economic activities generating the profits are performed and where value is created. As a result, the plan provides for 15 actions to be delivered by 2015 on various issues. As part of this plan, the OECD recently issued a report, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, as part of Action 6 of the BEPS action plan
The report includes a number of recommendations to check treaty abuse under different situations. These broadly include:
- The title and the preamble of a tax treaty should confirm that the purpose of the tax treaty is not intended to generate double nontaxation;
- Incorporating a specific anti-abuse rule in the treaty in the form of a limitation-of-benefits (LOB) rule;
- Incorporating a general anti-abuse rule that prevents the use of the tax treaty if one of the principal purposes of the transaction or the arrangement is to obtain the tax treaty benefit, unless it could be established that applying the treaty would be in accordance with the objectives of the treaty.
The specific LOB rule proposed to be included in the convention is similar to the one that exists in the Model Tax Convention of the United States and is found in most tax treaties that the United States has entered into with other jurisdictions. This rule provides a set of objective tests that have to be satisfied as a primary condition before applying the tax treaty to a given transaction. Such a specific rule will address a large number of treaty-shopping situations based on the legal nature of, ownership in, and general activities of taxpayers intending to take advantage of the tax treaty.General Anti-Abuse Rule
In addition to the specific LOB rule, the OECD has proposed to add a more general anti-abuse rule to address treaty-avoidance cases, including treaty-shopping situations that are not covered by the specific LOB rule.
The proposed Paragraph 7 providing for the general anti-abuse rule reads as follows:
7. 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.
The general anti-abuse rule proposed in the Model Tax Convention is consistent with the OECD's views expressed in the commentary to Article 1 (Persons Covered) of the Model Convention. According to that guidance, the benefits of a tax treaty should not be available where one of the principal purposes of the transaction(s) or arrangement(s) is to secure a benefit under a tax treaty that would be contrary to the tax treaty's objectives. The proposed Paragraph 7 incorporates the principles the OECD already expressed into the tax treaty itself to allow countries to address cases of improper use of the tax treaty even if the domestic tax law of the country does not permit this treatment.Tax Treaties and Domestic Tax Law
Under most countries' domestic tax laws, tax treaties generally prevail over domestic tax law when there is a conflict between the two. 1 Some countries have introduced a specific general anti-abuse rule 2 in their tax law that, subject to the fulfillment of the criteria under which it could be applied, gives taxing authorities the power to disregard tax treaties and apply the domestic tax law rules and even go as far as recharacterizing the transaction or the arrangement, if necessary.
Further, the courts of many countries have developed a number of judicial doctrines or principles of interpretation in the process of interpreting tax legislation in cases dealing with tax-avoidance situations. These include doctrines such as substance-over-form, economic substance, business-purpose, step-transaction, etc. These doctrines and principles of interpretation, which vary from country to country, are applied by the countries' tax authorities and courts to interpret tax legislation.
Where tax treaties are amended and the general anti-abuse rule on the lines of Paragraph 7 is included, there may not be a direct conflict as long as the principles behind the general anti-abuse rule under domestic tax law or judicial doctrines conform to the principles behind Paragraph 7. It is only when the domestic tax laws of a country do not include a general anti-abuse rule or the judicial doctrine or principles are somewhat less restrictive or do not apply in the context of tax treaties that the general anti-abuse rule under the tax treaty may give specific legal recognition to the principles of treaty abuse.Interaction of Anti-Abuse and LOB Rules
When compared to the Model Convention of the OECD, the Model Convention of the United States does not specifically include the general anti-abuse provision as outlined above. Nevertheless, the anti-treaty-shopping rules of case law, 3 the Code, 4 and the regulations could apply to deny the treaty benefits even if permitted under the LOB rule.
Accordingly, the above general anti-abuse rule would seek to deny the tax treaty benefit even if the primary objective criteria or the LOB rule is satisfied. That a company is a "qualified person" (e.g., its shares are traded on a recognized stock exchange in the country of residence) under the primary objective criteria does not mean, however, that benefits could not be denied under Paragraph 7 for reasons that are unrelated to the ownership of the shares of that company.
For example, if that public company is a bank that is otherwise qualified to benefit from the tax treaty, it may enter into a conduit financing arrangement and attempt to access the benefit under the tax treaty from the source country. The general anti-abuse rule could be applied, and the benefit of the tax treaty could be denied to the bank if it is established that the principal purpose of the transaction or the arrangement that the bank had entered into was with the intent to avoid taxes in the source state.
Example: A Corp. is a resident of country P. A Corp. owns C Corp., a wholly owned subsidiary in country R. A Corp. intends to fund C Corp. through an intercorporate loan. However, under the tax treaty between countries P and R, R will levy a withholding tax on the interest C Corp. pays to A Corp. under the intercorporate loan.
But the tax treaty that country R has executed with country Q exempts the withholding tax when a resident of country R raises external debt from a bank based in Country Q. Accordingly, A Corp. places a deposit with a bank in country Q (Bank B), and the bank subsequently finances C Corp. with a similar amount and keeps a minimal spread on the interest. Without the deposit placed by A Corp., Bank B would not have lent to C Corp. on the same terms and conditions as it did. Accordingly, in such a scenario, the general anti-abuse rule under Paragraph 7 may apply to deny the benefit of a lower or a zero withholding tax rate provided in the tax treaty between country Q and country R on the interest payments C Corp. makes to Bank B, regardless of the fact that Bank B will be able to meet the LOB rule in the tax treaty. As a consequence, the source country R may disregard the tax treaty and apply the withholding tax under the domestic tax law to the interest payment C Corp. makes to Bank B.Possible Effects of Anti-Abuse Rule
While it is possible to lay down objective criteria for determining whether the LOB rule is satisfied under a given set of facts, it is not possible to specify similar objective criteria to determine the applicability of the general anti-abuse rule. Accordingly, introducing a general anti-abuse rule in tax treaties calls for countries to assume a greater degree of responsibility to ensure that the rule is not applied by the tax authorities in inappropriate cases, thereby causing taxpayers uncertainty and unpredictability about whether they are eligible for the benefits of a treaty. If these anti-abuse rules are not properly administered, taxpayers may find themselves unnecessarily facing dispute resolution procedures that can be time-consuming and costly.
Accordingly, before a country adopts a policy of incorporating the general anti-abuse rule into the tax treaties that it negotiates or renegotiates, the country should do a serious evaluation to determine whether it has adequate administrative capabilities and institutional framework to ensure that the very objective of tax treaties (i.e., avoidance of double taxation in the course of international trade) is not undermined by adopting the rule.
This includes steps such as ensuring that the country's tax inspectors are equipped with the right level of training and experience to be able to make a sound judgment on the circumstances under which the general anti-abuse rule should be applied. Detailed administrative guidance should be issued by the tax administration in the country to make sure that the general anti-abuse rule is not applied as a matter of routine, and these rules should be carefully applied only in cases where there is a prima facie case for material tax avoidance. Further, the presence of an independent or quasi-independent institution in the source country that is able to deliver a letter ruling providing an advance clearance based on the specific facts and that considers the general anti-abuse rule, among other tax treaty provisions, will also help minimize disputes.
These are some of the policy measures that countries should consider before accepting the OECD's recommendation to adopt the general anti-abuse rule, assuming this is included in the final report in its current form, and renegotiating their tax treaties to include these recommendations.
1 Article 26 of the Vienna Convention on the Law of Treaties.
2 Called a general anti-avoidance rule in some countries.
3 Aiken Indus., Inc., 56 T.C. 925 (1971); Northern Indiana Pub. Serv. Co., 105 T.C. 341 (1995), aff'd, 115 F.3d 506 (7th Cir. 1997); Del Commercial Properties, Inc., 251 F.3d 210 (D.C. Cir. 2001).
4 Sec. 894(c) and its regulations deny treaty benefits for certain payments made to hybrid entities. Further, Sec. 7701(l) and the anti-conduit regulations give the IRS the power to disregard certain intermediate parties in a finance arrangement for withholding tax purposes to prevent avoidance of tax.
|Sushant Mehta is a director, International Tax Services, for PricewaterhouseCoopers LLP in New York City. For more information about this article, contact Mr. Mehta at firstname.lastname@example.org.|