On 16 September 2014 the OECD issued its paper Preventing the Granting of Treaty Benefits in Inappropriate Circumstances(Paper).
The Paper follows a draft paper issued earlier in 2014, and considers Action Point 6 of the OECD's wider 15 point Base Erosion and Profit Shifting (BEPS) Action Plan.
The BEPS Action Plan as a whole is discussed in more detail in our earlier Alert, OECD releases BEPS Action Plan.
In this Alert we consider the main issues and options for taxation reform raised in the Paper.
The Paper outlines the OECD’s response to what has been identified as one of the most important sources of BEPS concerns – international tax treaty abuse and particularly treaty shopping.
To address this concern, work has been carried out by the OECD to:
- Develop model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances.
- Clarify that tax treaties are not intended to be used to generate double non-taxation.
- Identify the tax policy considerations that (in general) countries should consider before deciding to enter into a tax treaty with another country.
The Paper recommends that the OECD model tax treaty and commentary be amended to include a minimum level of protection against treaty abuse. Two tests and a number of model treaty provisions (and related commentary) are proposed. This is intended to offer alternatives and flexibility for individual States, allowing for constitutional or European Union restrictions, with the common goal of ensuring that States incorporate sufficient safeguards in their treaties to prevent abuse. The two tests are a United States-style limitation of benefits rule (LOB) and a European-style principle purposes test (PPT).
This limits the scope of treaty provisions (i.e. benefits under a double tax agreement) to a resident that is also a 'qualified person'. A 'qualified person' is defined by reference to the nature or attributes of various categories of person. The definition is intended to ensure that a resident has a sufficient level of beneficial interest in the State in which it is claiming tax treaty benefits as a resident. Additionally:
- a person who is a resident but not a qualified person is still entitled to treaty benefits with regard to particular items of income, where that income is derived in connection with the active conduct of trade or business in the State;
- 'derivative benefits' provisions allow certain entities owned by residents of other States to obtain treaty benefits that those residents would have obtained had they invested directly; and
- the competent authority of the Contracting State has discretion to grant a treaty benefit to a person who would otherwise be denied that benefit under the LOB provisions.
The LOB test is based on objective criteria and so provides more certainty than the PPT rule. However, it does not capture all forms of treaty shopping (in particular conduit financing) and does not address all forms of treaty abuse.
The PPT test is whether 'one of the main purposes' of an arrangement or transaction that results in a treaty benefit (having regard to all the relevant facts and circumstances) was to obtain that treaty benefit. Such a treaty benefit will not be granted, unless it is established that the 'granting of that benefit in the circumstances would be in accordance with the object and purpose of the relevant provisions of the treaty'.
The PPT test is a more general way to address treaty abuse and captures some treaty shopping situations that would not be covered by LOB provisions (i.e. certain conduit funding arrangements). However, it involves more uncertainty than LOB provisions, and requires case-by-case analysis of what can reasonably be considered to be one of the principle purposes of transactions or arrangements.
Minimum level of protection in tax treaties recommended
The Paper recommends that tax treaties should incorporate a minimum level of protection from abuse. This minimum should include:
- an express statement in the title/preamble of the treaty that the common intent of the parties is to eliminate double-taxation without creating opportunities for non-taxation or reduced taxation through evasion or avoidance, including through treaty shopping; and
- combined LOB and PPT provisions; or
- provisions enacting the PPT rule; or
- provisions enacting the LOB rule, supplemented by a mechanism to deal with conduit arrangements (i.e. a restricted PPT rule applicable only to conduit financing arrangements or domestic anti-abuse rules/judicial doctrines that achieve a similar result).
Tax policy considerations before entering into a tax treaty
It is also recommended that a number of policy considerations identified in the Paper should be considered by States before they decide to enter into a tax treaty. The Paper states that these policy considerations are intended to help States explain their decisions not to enter into tax treaties with certain low-tax or no-tax jurisdictions. The key policy consideration identified by the Paper is the extent to which the risk of double taxation exists in a cross border situation involving a State’s residents.
The model treaty provisions and related commentary contained in the Paper should be considered as drafts and are subject to further improvement before the final versions are released in September 2015. The Paper recognises that further work is needed on:
- the precise contents of model provisions and commentary (especially the LOB rule); and
- the policy considerations relevant to the treaty entitlements of collective investment vehicles (CIVs) and non-CIV funds.