I am delighted to announce that our move to Regent’s Park was completed with the minimum of disruption – in fact, our server was down from 5pm on the Thursday of our move from Clarges Street until just 11am on the Friday morning, so well done our IT specialists. In case you find emails to our previous server bouncing back (despite maintaining the same domain name), please note that we are now properly ‘tutoyé’d’ as the French say, so I am now simply firstname.lastname@example.org. I look forward to welcoming you here in the near future.
During the past 2 weeks, I have been in Paris, Malta and Zurich, so my travelling has not abated. Lara and I were in Paris for the 50th Anniversary of the first draft of the OECD Model Double Tax Treaty in 1958 (before even MY time as an international tax practitioner!). Their ‘party’ to celebrate this achievement was in fact a Conference to review the latest treaty developments in the 2008 update, and in particular we discussed treaty shopping and permanent establishments in the current tax climate. I have summarised these discussions in this Newsletter as our first article below.
Now, talking about parties, an achievement nearer to home which merits a celebration is the 25th Anniversary of the first issue of my book ‘International Tax Systems and Planning Techniques’ published in 1983. I am proud to say that this 1000 page loose leaf work covering the tax systems of more than 30 countries, now in its 54th release, is still the leading international tax reference book on the market. My next target is to re-vamp the work to bring its style more up to date, but in the meantime, I am planning a party sponsored by my publisher Sweet & Maxwell on Tuesday, December 2nd at the St Martins Lane Hotel (where we had a launch party 2 years ago for my more recent book ‘Principles of International Tax Planning’). We will be sending out invitations in due course and hope to see you there.
In addition to my own article, we have two other articles in this Newsletter. The first is our regular country review which this month features Switzerland. Kay Hofmann of Marcuard Heritage receives our thanks for his excellent article describing the ‘forfait’ lump sum tax system (relevant for our UK non-dom readers who may wish to leave the Brown/Darling fiasco behind them), new guidelines on trusts, and also the new Swiss measures to attract hedge fund managers (ditto re Brown/Darling!).
Our final article has been contributed by Kishore Sakhrani and Elizabeth Thompson of ICS Hong Kong. Kishore and Elizabeth have been friends for more years than I (or they) would admit to, and they have written a fascinating article about China and its newest export: inflation!; what that means for the rest of the world – and why tax cuts may not be forthcoming.
I hope you enjoy reading this Newsletter. If you would like to make any comments, or better still contribute an article on your country for future Newsletters, please contact us at email@example.com .
OECD 50th Anniversary Special Conference
The Conference commemorating the 50th year anniversary of the publication of the first draft of the OECD Model Double Tax Treaty in 1958 started with our good friend Philip Baker reviewing the 10 most significant developments over the last 50 years. The 5 most popular topics are considered in this article:
- Beneficial Ownership Concept
- Attribution of Profits to Permanent Establishments
- EU Arbitration Convention
- First US Limitation on Benefits Provision
- OECD Transfer Pricing Guidelines
The jocular banter generated by Philip from a ‘reality show’ voting contest as to which was deemed by the delegates as the most important one was a valiant attempt to demonstrate to everyone why tax is such an exciting topic!
Beneficial Ownership Concept
The ‘Beneficial Ownership’ concept was first introduced in 1977 in order to exclude treaty shopping through specifically nominees and agents. The term was included under the dividend, interest and royalty articles of the Model Treaty in order to avoid such entities benefiting from reduced withholding taxes provided under these articles. However, the panel concluded that the inclusion of this term does not prevent treaty shopping through conduit companies. The Commentary refers to economic entitlement to the relevant income as well as control over that income, so that conduit companies involved in treaty shopping would only be excluded if they are acting merely in a fiduciary capacity for third parties.
The panel considered that there needs to be more certainty as to whether treaty shopping through conduit companies may still provide withholding tax benefits, and in this respect lauded the US Limitation on Benefits provision introduced in 1980 which was a fundamental change to the approach of tax administrations to treaty shopping.
Case law in different countries does not give conclusive determination of the term beneficial owner e.g. in Aiken Industries v CIR, the case held that Aiken had no ‘dominion and control’ over interest receipts from the US but merely temporary physical possession of the interest until it was paid out to the real beneficial owner (a non-treaty entity). On the other hand, several cases have concluded that banks are entitled to treaty benefits as the proper recipient of income even though they are acting for its clients.
In summary, it was concluded that conduit companies will be entitled to treaty benefits unless they enjoy very narrow powers over the income and effectively act as a fiduciary or administrator. We at IFS have always recommended that conduit companies, such as intermediate holding companies, have a sufficient degree of substance to refute any claim that they are merely acting in a fiduciary capacity for their shareholders.
The Indofoods v JP Morgan case was discussed in our Newsletter of 10 July 2006 (you can read the full facts by referring to our website www.interfis.com). In brief, the UK High Court ruled that the term “beneficial owner” means the actual owner of the interest income who truly has the full right to enjoy directly the benefits of that interest income. The Court held that a nominee or a conduit company is not regarded as a beneficial owner of the interest. The decision was not appealed and as such it is part of UK law – the extent to which it has an impact on UK tax law is debatable but it would appear HMRC have taken a keen interest in the case by scrutinizing special purpose finance vehicles, particularly those based in Luxembourg.
The French panellist from the tax administration said that they tend to interpret treaties in the light of the overall objective of the treaty and its purpose. Thus the title of the Model Treaty is ‘Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion’. Since the OECD Commentary states that the term beneficial owner cannot be narrowly interpreted, he argued that it should therefore be interpreted in the light of the purposes of the treaty. If the recipient (the conduit company in treaty shopping) is included merely to avoid French withholding tax, then it may properly be disregarded as the beneficial owner since the treaty is not in place to encourage fiscal evasion. Two French court cases in 1999 and 2006 even decided to apply the beneficial ownership concept despite the absence of the term itself in the relevant double tax treaties, using the ‘abus de droits’ provision as the reason for denying treaty benefits.
The Prevost Car case in Canada reviewed whether the beneficial owner should have the meaning under domestic law or international fiscal law. In that case, a Dutch holding company acted as an intermediary between UK and Swedish shareholders and a Canadian operating company, and was admittedly introduced in order to avoid most of the dividend withholding tax in Canada. Although there was a Shareholders’ Agreement regulating the onward dividend flow from the Dutch company, it was held that the company itself was not a party to it and therefore was not bound by an agreement of its shareholders. Therefore, it was not considered to be acting purely in a fiduciary capacity and it was indeed the beneficial owner of the dividend income and entitled to treaty benefits.
In another Canadian case, the MIL Investmentscase, a Cayman Island company moved its residence to Luxembourg in order to be able to avoid Canadian capital gains tax on the sale of a Canadian company, which would have been levied if the owner were not resident in a tax treaty jurisdiction. There is in fact no beneficial ownership requirement for the capital gains article to apply, but nevertheless it was held that the concept is implied in treaties. In the absence of any substance in Luxembourg, the true residence of the Cayman Island company would have been questioned. In the MIL case however, the Cayman Island company rented an office and had two employees, and was therefore considered to have the degree of substance to be considered resident in Luxembourg for the purposes of the treaty.
In summary, treaty shopping through conduit companies is generally defensible unless the company is acting merely in a fiduciary capacity for the ‘true’ beneficial owner. However, the French concept of ‘abus de droits’ as it relates to treaty shopping is clearly a warning that abusive treaty shopping is unacceptable, and the conduit company must have a proper degree of substance to benefit from double tax treaty arrangements.
Attribution of Profits to Permanent Establishments
The next topic involved a study of four different cases to examine the question as to whether a permanent establishment existed in different circumstances. It was interesting that representatives of the tax administrations in Germany, India and Australia had a totally different view of the interpretation of relevant facts than the professional tax lawyers who made up the rest of the panel!
Everyone agreed that the rules are quite clear. In order for a non-resident to be taxed in another country under the permanent establishment provisions of a double tax treaty, it must either (a) be conducting business within that country itself or (b) act in that country through an agent. As regards (a), (i) there must be a place of business at the disposal of the non-resident company, (ii) it must be fixed and (iii) it must be where the business of the company is carried out. As regards (b) above, the model treaty accepts that the activities of independent agents acting in the course of their business will not create a permanent establishment for the non-resident.
A Norwegian case considered whether a non-resident principal, which sub-contracted to a Norwegian company services required under a contract it had entered into to provide catering services on an oil rig in Norway, could be taxed on its ‘delta’ profits i.e. the difference between the main contract price and the amount that it paid to its sub-contractor. The differing views centred on how intensive was the degree of control of the non-resident over the duties of the sub-contractor, and therefore whether that sub-contractor could be considered as the agent only of the non-resident company.
However, in some of the case studies reviewed, representatives of the tax administrations said that they would rather rely on transfer pricing provisions rather than trying to deem a permanent establishment of the resident company in situations where their success would be in doubt. Thus in the above case, the profits that would be retained by the non-resident could be deemed to be excessive, and even if the non-resident principal and the sub-contractor are independent entities, tax administrations may seek to make a transfer pricing adjustment. Such an adjustment would be on the grounds that the payment to the sub-contractor does not adequately reflect the risk and reward profile that it undertakes for performing the entire services required of the non-resident principal (within Norway). The general consensus was that transfer pricing adjustments may be a more successful tool in attempting to impose local taxation on a non-resident company that earns income from a local source. This is particularly so if the profits under question may not be attributed to a local permanent establishment.
Mutual Agreement Procedure and Dispute Resolution
It is well known that where disputes arise as to the tax treatment of particular items of income, taxpayers are reluctant to involve the Mutual Agreement Procedure (MAP) of double tax treaties by applying to the Competent Authorities to determine the position. The time and expense of doing so, and the uncertainty of the outcome, discourages all but the desperate. However, dispute resolution under the MAP provisions has now been strengthened by a new paragraph 5 of article 25 which includes an arbitration clause if MAP is not agreed within two years. However this arbitration clause is not binding on the tax administrations if they cannot agree and therefore there is still the same potential impasse.
So, the first day of the Conference ended and I have to confess that I skipped the second day and returned to London on the morning flight. I guess I simply couldn’t take any more excitement in one week! However, Lara stayed for the second day as well and you may be hearing from her direct in next month’s newsletter as to what was covered during the remaining part of the Conference.
Switzerland’s Role in International Tax Planning
Switzerland is a highly attractive jurisdiction for international tax planning, for some too attractive! The European Commission regarded the cantonal taxation of holding and administrative companies as a form of state aid not to be compatible with the 1972 Free Trade Agreement between the EU and Switzerland. The Swiss Federal Council considers this interpretation of the FTA by the EU to be unsubstantiated and rejects any negotiations. However, the Swiss government is nonetheless prepared to hold a dialogue in this matter in order to clarify the mutual positions and to improve the understanding of the Swiss tax system.
Having a small and open national economy, it is essential to constantly improve Switzerland’s legal and fiscal framework for corporate and individual taxpayers. Recently, there have been some major developments and IFS’ readers should become aware of at least the following two:
Firstly, on July 1st, 2007 the Hague Trust Convention came into effect in Switzerland after its ratification by the government. Based on this, the tax authorities issued a circular letter in order to harmonize the taxation of trusts for federal and cantonal tax purposes. And there is some good news; neither a trust nor a Swiss based trustee is taxed on the trust assets and the income thereof. A Swiss trustee is only liable for income taxes on his fees earned (the same is true for Protectors). Taxation of settlors and beneficiaries who are tax resident in Switzerland is more complex. These legal and fiscal clarifications have made Switzerland even more attractive for professional trustees. A good number of trust companies have newly been established and in addition, the Swiss Association of Trust Companies has been founded for the furtherance and development of trustee activities in Switzerland.
Secondly, ever since last year’s introduction of the Swiss limited partnership as a new vehicle for Private Equity funds, the income tax treatment of distributed carried interest (performance fee) in the hands of the fund manager has been a hot issue for the following reasons: A capital gain realized following the sale of shares by an individual investor is tax free in Switzerland, but only if the shares have been held as private assets (note that the Swiss limited partnership itself is treated tax transparent). Good arguments have been put forward to qualify the carried interest received by the fund manager as a tax-free private capital gain. However, the tax authorities had taken the view that the whole carried interest should be subject to income tax at ordinary rate because the carried interest is effectively connected with the manager’s activity for the fund.
However, with the new act on collective investment schemes, Switzerland wanted to boost its attractiveness for fund managers, but the uncertain tax treatment of the carried interest has prevented fund managers from moving to Switzerland in large numbers. Cooperation efforts between the finance sector and the authorities have eventually resulted in a draft of new guidelines on the taxation of performance fees and carried interest. The final version of these guidelines is expected to be published in November of this year but it is believed they will be beneficial for the fund managers so that carried interests will be treated as a (non-taxable) capital gain as opposed to a (taxable) trading receipt.
And finally, not a new measure but nevertheless attractive is the special tax arrangement available for foreign citizens fulfilling certain requirements. Moving to Switzerland and being subject to the so-called lump-sum taxation has particularly been considered by some UK resident non-domiciled individuals after the recent changes in UK tax law. In a nutshell, taxes are levied on the basis of living expenses in Switzerland rather than on worldwide assets and income. The lump-sum taxation does not allow carrying out gainful activities in Switzerland; indeed it is aimed at financially independent individuals who are not seeking employment here.
IFS would like to thank Kay Hofmann for the above article. Kay is a Certified Tax Expert, LL.M. (Tax), TEP and Head of Legal and Tax at Marcuard Heritage AG and Managing Partner at Marcuard Trust AG. Their website is www.marcuardheritage.com.
China’s Newest Export: Inflation
In understanding China’s impact on the West, a useful rule of thumb went as follows: “If China uses it, the price will go up. If China makes it, the price will go down”. That relationship has held true for well over the last decade but recently, the second part of that adage has broken down quite dramatically.
Over the last decade, Chinese ex-factory prices only declined, what with cheap labour, access to cheap capital, a devalued currency and, in some instances, subsidized commodity prices. However, in the last year or two, prices of Chinese made goods have been rising materially, with price increases of 10% to 20% a year not uncommon.
We believe that the age of deflationary exports is over and that an extended period of inflation in Chinese made goods is just beginning. This has serious ramifications for inflation in the Western economies, as China has essentially become the factory to the world, particularly in many consumer items.
Why are prices in China going up? There are a number of short term factors, such as the recent currency revaluation. However, we believe that there are a number of longer term causes to this inflationary pressure, most of which are not easily reversible.
Shortage of labour:
Surprising as it may seem, China is starting to experience a shortage of cheap, young labour, the source of much of China’s competitive advantage for the last two decades. Chinese official statistics indicate that the number of people between the ages of 15 to 34 have declined from 443 million in 2000 to 380 million in 2005, a decline of 14%. Allied to this has been a general decline in population growth in the last several years.
This shortage of labour has been exacerbated by the growing unwillingness of young Chinese to move from the country’s interior to the sweat/workshops on the coast. What with China’s one-child policy and an underdeveloped social welfare system, many young Chinese are unwilling to leave their ageing families. Economic reforms and revitalizations in the Chinese interior mean that they don’t have to leave to find work.
Changes in China’s employment legislation:
At the start of 2008, sweeping changes to China’s employment legislation came into effect. These changes seek to improve the working conditions and tenure of China’s workforce, thereby reducing the impact of many of the exploitative labour practices so prevalent in the manufacturing sectors. A major investment bank estimates that the upshot of these changes is a permanent increase in labour costs of between 10% to 20%.
These changes in the labour situation mean that the current wage inflation now prevalent in many sectors of the economy is not merely cyclical but likely marks the beginning of a structural realignment of China’s labour costs.
Growing middle class:
The emergence of a Chinese middle class has caused an explosion of demand for consumer goods. As a result, many firms have moved production away from the export sector to the burgeoning domestic market. As Chinese consumers increase their standard of living, demand for all kinds of commodities will continue to increase. We believe that we are in the relatively early stages of a secular uptick in commodity demand, with higher commodity prices the end result.
What does this mean for the West?
Higher prices, for all kinds of hard and soft commodities are here to stay. There will be short term corrections, but the long term trend line is clearly up. Western consumers will find their cost of living increasing as much of what they buy has a Chinese component. In the face of an increasing cost of living, will consumers in the West continue to be satisfied with relatively low wage increases or will wage pressures start to intensify?
As China moves from being a source of deflation to one of inflation, the flexibility of Central Bankers everywhere will decrease and, as a result, interest rates in the West are likely to be higher than they otherwise might have been. Traditionally, economic growth is stimulated by low interest rates or tax cuts. With higher than desirable interest rates, tax cuts are unlikely to achieve anything other than a neutralizing effect. Global economic growth will therefore be affected unless Governments join forces to address the impact of China’s newest export.
IFS would like to thank Kishore Sakhrani for the above article. Kishore is a director of ICS Trust (Asia) Ltd, a Hong Kong based trust company that provides a range of services to North American and European companies looking to do business in Asia. Their website is www.icstrust.com.