Lehman Brothers collapsed on 15 September 2008, and since that time there has been an unprecedented interest in protecting government budgets, with tax avoidance being as high on the agenda as bank capital adequacy. This may have heralded the start of the OECD project called ‘Base Erosion and Profit Shifting’ (BEPS), which the G20 action group had requested. The emphasis of the OECD was to rid the international business world of artificial tax structures, and this of course has raised the issue of artificiality above the parapet. It has always been presumed that adequate substance within any entity assumes that the structure is not artificial, but there is a real question mark as to what constitutes ‘substance’.
What is Substance?
The Netherlands has taken a lead in attempting to define whether substance exists within any entity in an international business structure. The Netherlands has always been the jurisdiction where holding companies, finance companies and licensing companies have been created to minimise the tax burden of international corporations, so it is no surprise that there is a greater volume of foreign direct investments routed through the Netherlands than in any other country, even the US. The Dutch government has been trying to deflect its perception as a tax haven for more than 20 years, but has now brought in legislation which it hopes will discourage the use of Dutch companies in artificial situations.
Let me use a simple example of a Dutch holding company owning a foreign subsidiary company, and itself being owned by a foreign parent company. The new substance requirements demand that both subsidiary and parent company have office premises and an annual salary cost of employees of €100,000. In the absence of meeting these two requirements, dividends from the foreign subsidiary company will not be exempt under the holding company participation exemption rules, and dividends paid by the Dutch company to its foreign parent company will be subject to withholding tax and not be exempt.
But is it necessary for a foreign parent company with just one asset, the Dutch holding company, to employ staff at a cost of €100,000 per annum to demonstrate that it has the requisite substance to be able to take decisions relating to its one asset. Or a finance company with one loan? Or a licencing company with one licence agreement? And why aren’t the same substance rules applied to the Dutch holding company itself with just one asset, the foreign subsidiary company? The new rules don’t apply to domestic companies which seems strange if one is trying to define what substance is!
The Multilateral Instrument (MLI)
The BEPS initiative has fifteen action points to combat tax avoidance, which I have described in detail in previous newsletters. One of the action points, and a major target of the OECD, is to prevent the abuse of double tax treaties to create double non-taxation, or minimise withholding and other tax impositions if this does not accord with the intentions of the bilateral parties to the double tax treaty. The recommendation in BEPS has now been embodied in the so-called Multilateral Instrument (MLI) which is intended, at a stroke, to implement the BEPS recommendations without bilateral parties having to re-negotiate each and every of the 2,500 plus double tax treaties that exist.
68 countries signed the MLI on 7 June 2017, and a further 10 have since signed it so that it is in now in force and will be applicable to withholding taxes from 1 January 2019, to corporation tax in the UK from 1 April 2019 and to income tax from 6 April 2019. The problem is that when adopting the MLI, countries are entitled to elect to amend or exclude certain provisions, and thus it may be that where the adoption of the MLI is not identical between two countries, one would have to revert to the original double tax treaty to clarify taxing rights and rates of taxes. The international tax consultant will have his or her work cut out to identify whether the MLI is relevant or not.
Besides the uncertainty of whether a particular double tax treaty is covered by the MLI, my main objection is that although Articles 16 and 17 discuss the mutual agreement procedures where dispute resolution cases should be brought before either Competent Authority, and the principle of reciprocal adjustments should be accepted, there is no binding requirement of the bilateral party to agree on disputes, nor is there a mandatory arbitration clause. Undoubtedly, even if the MLI is applicable to, for example, the definition of a permanent establishment, where the two countries cannot agree on relevant adjustments to tax assessments that may have been made, the rights of the tax payer cannot be automatically enforced through the MLI.
The Principal Purpose Test (PPT)
Article 6 of the MLI states that there should be a preamble to all treaties to include as its intention ‘to eliminate double taxation with respect to the taxes covered by the agreement without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty shopping arrangements aimed at obtaining reliefs provided in this agreement for the indirect benefit of residents of third jurisdictions)’.
Article 7 then introduces the ‘principal purpose test’, which states that the treaty is inapplicable if obtaining the relevant treaty benefit was one of the principal purposes of an arrangement or transaction, unless in accordance with the object and purpose of the treaty.
So, besides the uncertainty around substance, we now have the uncertainty around the applicability of the MLI to double tax treaties, and indeed the principal purpose test only requires there to be a tax objective (even if the structure otherwise is entered into fully for commercial reasons) for the treaty to be inapplicable. Such subjectivity (the principal purpose test and substance) is undesirable and their interpretation may only be understood in future once court cases have been adjudicated.
So BREXIT is not the only issue creating considerable uncertainty in the current business climate. The clampdown on tax avoidance must be welcomed and I believe is fully accepted by most reputable international tax consultants. At the same time, countries are still vying with each other to provide tax incentives where commercial activities are undertaken for the benefit of the economy (which of course requires ‘substance’) and are designed to encourage employment of appropriate personnel. Thus, the patent box regimes in the UK, Ireland, Netherlands, Luxembourg and many other countries introduce tax rates from 2.5% in Cyprus to 5.2% in Luxembourg to 6.25% in Ireland and 10% in the UK.
Let’s suppose a client wants to create a research and development company and hopes to obtain minimum withholding taxes incurred on future royalty income from say Brazil. Brazil doesn’t have a double tax treaty with the UK or Ireland but does have one with Luxembourg which affords benefits in respect of royalty income derived from a Brazilian company. So the client sets up an R & D operation in Luxembourg which can benefit from the 5.2% corporate tax rate and no withholding tax on distributions. Despite being a full valid entity with substance which meets the intentions of the Luxembourg government to encourage R & D operations in the country, there may indeed be no argument that one of the principal purposes of setting up such an operation is to achieve relevant treaty benefits with Brazil.
I will be examining some of these issues at the IBSA conference on 1 November to be held at The Berkeley hotel, Knightsbridge, London, with several colleagues where we review a fictitious case study of my creation, and consider the issues whereby an entrepreneurial project can develop into an international business. Besides considering the international tax structure with colleagues from the US, Netherlands, Luxembourg, Switzerland, Russia and the UK, I will discuss the issue of BEPS, the MLI and fairness in taxation with Philip Baker QC and Filippo Noseda. The conference will also consider non-tax issues such as how to protect the intellectual property created by the entrepreneur, and how to finance the development of the business using crypto currency and other new concepts of finance. To reward my long suffering readers of my newsletters, you can register for the conference at the discounted rate of £450 (instead of £750) by applying the code IFS18.
As for BREXIT, I am still hopeful for a fudged agreement on the lines of a Canada + arrangement of free trade, but allowing free movement labour for a transitional say ten year period to prevent a hard border requirement in Ireland. In other words, the old political trick of kicking into touch anything that cannot currently be resolved and leaving the problem with a future government. We shall see!
With kind regards