My mind this month has quite naturally been geared to the process of creation, and I am delighted to announce the birth of baby Lila to my daughter Lara and her husband Adam Arnold. Lila is of course the most beautiful baby that has ever been born and although two weeks early at 5lbs 7ozs she is a sturdy little bundle of perfection. I have attempted throughout my career to be as creative as possible, but I have to admit abject failure to come anywhere near Lara’s achievement! Both mother and daughter are doing brilliantly.
The ITSAPT club
As Lara is not going to be around to help me for the next four months, I thought I might give myself (and you the reader) a break from our IFS newsletters during the summer and bring the next one to you in October, when Lara returns. Until then, and to enable her to look after Lila at the same time,, she will be working on the re-vamp of “International Tax Systems and Planning Techniques” which is being changed from the loose-leaf work that has been the leading international tax reference book since 1983, to a bienniall bound book with yearly updates. Sweet & Maxwell, its publishers, have asked IFS to continue with the work after 26 years of successful editions totalling 58 releases.
What is exciting to me is that I have asked specific tax advisors in the 30 or so jurisdictions covered by the book to join me in an informal ITSAPT Limited Partnership where each member takes responsibility for his country but also agrees to cooperate with each other to assist on client matters. In other words, a sort of informal network of specialists who I believe are able to provide the best advice to our clients as well as their own group of clients on international tax matters. I plan to hold an annual conference at which the ITSAPT LP members will join me in London in discussing international tax issues of current interest. The conference will be open to delegates from all over the world, and the first will probably be in mid 2010.
Can we rely on Double Tax Treaty provisions any more?
One of the current issues which we will be discussing is going to become of greater significance in the future than it was in the past; that is whether we are able to rely unreservedly on the provisions of double tax treaty arrangements in force in order to create appropriate structures for our clients. The use of intermediary holding companies, finance and licensing companies rely on the ability to minimise foreign withholding taxes according to double tax treaty arrangements, whilst trading companies want to be sure that they are not going to be taxed in another country and want to rely on the permanent establishment clause of a treaty to avoid a fiscal presence in that other country; and individuals may move to a particular country in order to obtain benefits from personal income rights that are afforded by a particular treaty.
35 years ago when I started practising as an international tax consultant, one didn’t even have to think whether one could rely on a double tax treaty – simply look at the wording of the treaty and create an entity to take advantage of the relevant provisions. Picking a company off the shelf in the Netherlands or Luxembourg and interposing that between two or more business entities was a perfectly natural thing to do. Then along came the US which started to override the provisions of double tax treaties without recourse to the other country (the contracting party) – so much so that the current Swiss/US Treaty contains a provision that no treaty override will be permitted unless a mutually agreed reciprocal benefit is afforded to the contracting party.
The ability of the US to override treaty arrangements stems from the US constitution in which the provisions of international agreements and those of domestic legislation have equal status. So when the US implemented “The Foreign Investment in Real Property Taxes Act” in 1981 (FIRPTA), it did not need to renegotiate double tax treaties in order to implement the FIRPTA provisions. No superior status is given in the US to treaty legislation over domestic provisions, unlike the case for example in France and the Netherlands where it is expressly stated that international agreements take precedence over subsequent domestic legislation.
Certain constitutions such as Luxembourg and Belgium require international agreements to be incorporated into the domestic law of the countries, but limit the ability of subsequent domestic legislation to amend the provisions of those agreements, so again treaty overrides would not be permitted. In the UK however, although international agreements also have to be incorporated into domestic law before they become effective, Court cases have confirmed that Parliament may take away anything that it has given, ie Parliamentary supremacy would permit treaty overrides. And in 2008, that is exactly what they did by providing in Section 59 of the Finance Act 2008 that UK residents could not rely on qualified double tax treaty provisions to override UK legislation.
The scourge of Treaty Shopping
As an advanced warning to the world that the US would not accept “treaty shopping” arrangements, the 1992 US/Netherlands double tax treaty brought in a two page “Limitation of Benefits” provision which effectively prevented Dutch companies not owned by Dutch residents from benefiting from any of the treaty provisions. Even those entities owned by Dutch residents would not be able to benefit if 50% or more of the income received under the treaty benefited from lower withholding taxes and was paid to non-residents who would not be so entitled to such tax mitigation on a direct receipt of such income (the base erosion test). These Limitation of Benefits provisions are now common in all US treaties that have been renegotiated since 1992.
Case law developed by various countries has also succeeded in limiting the benefits of treaties to those who are actually beneficially entitled to the income. For example, the dividend and interest articles of double tax treaties have a requirement that the recipient must be the beneficial owner of the income in order to obtain treaty benefits. There have been many cases which have reviewed whether a recipient entity is indeed the beneficial owner of the income, particularly where that entity has no real substance and is only, in effect, a virtual entity established in a particular jurisdiction for the purposes of taking advantage of the treaty. Cases such as Indofoods v J P Morgan in the UK and the Prevost and MIL Investments cases in Canada can explain the way Courts are thinking in this regard.
Is the objective of the Treaty being fulfilled?
However, there have been few cases which have looked at whether a treaty should apply at all if the object and purpose of the treaty is not being fulfilled appropriately. Regard could be had to Article 31 of the Vienna Convention on the Law of Treaties which states “the treaty should be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose”. It is not a great leap from considering whether specific provisions apply, to looking at whether the treaty as a whole should be disregarded. After all, the heading of any double tax treaty will generally read “Agreement between X country and Y country for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income”. If an off the shelf entity without any substance is interposed in a particular structure with the object of avoiding taxation in the source State, and it has no other commercial purpose in life and no substance, then tax authorities should quite properly question whether the object and purpose of the treaty are being fulfilled. Is double taxation being avoided, or are the taxes of just one country being avoided, and is the interposition of the virtual company assisting with fiscal evasion rather than preventing it?
The UK authorities seem reluctant to pursue this argument in Court cases, such as the Smallwood case, but the French have taken issue with a particular structure using this argument successfully. The Yanko-Weiss case in Israel in December 2007 held that a general anti-avoidance concept is implicit when applying double tax treaties. It cites Article 26 of the Vienna Convention which states that the treaties must be performed in good faith, and the case stated that treaties must not be used to abet tax evasion.
There is, however, a contrary argument that is in fact the basis of the Vienna Convention which suggests that the text of double tax treaties must be presumed to be the definitive intentions of the contracting parties. Therefore, although unwritten intentions of the parties should be considered, the meaning of the text itself coupled with the customary interpretation already exercised by the contracting parties should be of paramount importance. In summary, generally Continental civil law jurisdictions might suggest that literal interpretations may be at variance with the purposes of the treaty as a whole, while Anglo-Saxon countries may be reluctant to deny the actual text of a particular treaty (although the US seem quite happy to do this).
Uncertainty for the future
What is certain is that automatic treaty shopping as we all practised it 35 years ago is no longer on the agenda and we must all ensure that any corporate entity within a structure has to have commercial validity. It needs to have sufficient substance to ensure that it is indeed resident in the jurisdiction where is it claiming treaty benefits, and that it is not undermining the intention behind the treaty as a whole if it is included within a relevant structure. In today’s economic climate requiring investment opportunities to rekindle global growth, one would have thought that impediments to making investments (such as the uncertainty outlined above) would be counter-productive. Unfortunately, Revenue authorities often fail to see the wider picture so that preservation of a 5% withholding tax differential becomes more important than whether the investment actually takes place. And after all, the principal purpose of a double tax treaty, as highlighted in paragraph 7 of the Commentary to Article 1 of the OECD Model Treaty is “to promote … exchange of goods and services, and the movement of capital and persons”.
Clearly, we at IFS need to maintain our creativity in order to help with the impetus required for new global growth, but at the same time we need to be aware of trends in the attitude of Revenue authorities and Courts as regards the reliance we can place on double tax treaty arrangements.