Sometimes, companies are set up in jurisdictions merely to obtain the tax benefits that are granted under the relevant tax treaty, whilst the chosen structure in reality has little commercial substance. Tax authorities worldwide are aware of these so-called treaty shopping practices and have become more and more sophisticated in combating such misuse of tax treaties. In this article I will discuss some of the tools available to tax authorities in targeting treaty shopping. Being aware of these tools is essential when establishing the most appropriate and efficient tax structures for cross-border activities.
Most countries are using the OECD Model Convention as the basis in their negotiations with other States to conclude bilateral tax treaties and in the first part of this article I will provide a brief summary on the general purpose of the Model Convention. In the second part of this article I will deal with some of the provisions that are embedded in the Model Convention and in some other bilateral tax treaties that can be used against treaty shopping. Since anti-treaty shopping provisions can also be found in domestic legislation and when applied would override the relevant tax treaty, I will furthermore provide an example of local anti-treaty shopping legislation. In the last part of this article I will touch upon the so-called Controlled Foreign Companies (“CFC”) rules that many jurisdictions have incorporated in their domestic legislation. Although these rules do not specifically target treaty shopping, they can have a significant impact on international tax structures and I will conclude this article with a brief summary of the current status of the compatibility of CFC rules with tax treaties.
OECD Model Tax Convention (2005)
The main purpose of the OECD Model Tax Convention on Income and on Capital, is to provide a uniform basis to settle the most common problems of international double taxation. International double taxation is defined as the imposition of comparable taxes in two (or more) States on the same taxpayer in respect of the same subject matter and for identical periods.
The Model Convention does not deal exclusively with the elimination of double taxation but also addresses other issues, such as the prevention of tax evasion and non-discrimination. More recently, some members have even indicated that the Model Convention should also prevent unforeseen non-taxation that could be the result of applying tax treaties. Members of the OECD should conform to the Model Convention, when concluding or revising bilateral tax conventions that are based on the Model Convention.
The main part of the Convention is made up of Chapters III to V, which settle to what extent each of the two Contracting States may tax income and capital and how international double taxation is to be eliminated. This part contains two categories of rules.
The first category or rules allocate the taxing rights of different classes of income and of capital to the State of source or the State of residence. Three classes can be distinguished:
1. income and capital that may be taxed without any limitation in the State of source,
2. income that may be subjected to limited taxation in the State of source, and
3. income and capital that may not be taxed in the State of source.
Where an exclusive right to tax is allocated to one of the Contracting States, the other Contracting State is thereby prevented from taxing those items and double taxation is avoided. Generally, the exclusive right to tax is allocated to the State of residence. However, with regards to certain types of income such as interest, dividend and (under most bilateral treaties) royalty income, both States have the right to tax, albeit that the amount of tax that may be imposed in the State of source is limited.
The second category of rules determine that where the State of source has limited or full right to tax, the State of residence must provide relief in order to avoid double taxation. The methods of relief granted are either based upon the exemption method or upon the credit method.
Where a resident of a Contracting State receives income from sources in the other Contracting State, or owns capital situated therein, that in accordance with the Convention is taxable only in the State of residence, no problem of double taxation arises, since the State of source must refrain from taxing that income or capital.
Anti-abuse Provisions in Tax treaties
The Convention and bilateral tax treaties contain a number of tools that could be used by a Contracting State against treaty shopping. I will discuss here only the most significant ones.
Residence: place of effective management
In order to claim the benefits of a tax treaty the claimant needs to be resident of at least one of the contracting states. Once it is determined what the State of residence is, the tax treaty then allocates the taxing rights of the various items of income and capital to the State of source and the State of residence. Furthermore, this article also tries to resolve double taxation as a result of dual residence and to this extent includes a so-called tie-breaker clause which determines the State of residence in case of dual residence.
Under the tie-breaker clause the State of residence for companies is determined according to where its place of effective management is situated. It is the tie-breaker provision that can be used as an anti-abuse measure. In the example shown below, the Jersey Parent provides a loan to Luxembourg Finance Co, which in its turn on lends the funds to the UKCo.
In principle interest payments are subject to UK withholding tax of 22%. However, on the basis of the Luxembourg-UK tax treaty the withholding tax is reduced to 0%. Had the loan been granted directly by Jersey Parent to UKCo, the withholding tax due in the UK would not have been reduced under the Jersey-UK tax treaty. If all decisions of the Luxembourg Finance Co effectively would be made in the UK, HMRC could claim that on the basis of the tie-breaker rule, Finance Co is resident in the UK. As a result there would be no need for HMRC to apply the tax treaty and the granting a reduction of withholding tax on the interest payments is therefore not in point.
In determining the meaning of beneficial owner a significant weight is given to the OECD publications. In 1986 the OECD published a report entitled ‘Double Tax Convention and the Use of Conduit Companies’ (the Conduit Companies Report). In paragraph 14(b) it was stated that:
‘Articles 10 to 12 of the OECD Model deny the limitation of tax in the State of source on dividends, interest and royalties if the conduit is not its “beneficial owner”. Thus the limitation is not available when, economically, it would benefit a person not entitled to it who interposed the conduit company as in intermediary between himself and the payer of the income (paragraphs 12, 8 and 4 of the Commentary to Articles 10, 11 and 12 respectively). The Commentaries mention the case of a nominee or agent. The provisions would, however, apply also to other cases where a person enters into contracts or takes over obligations under which he has a similar function to those of a nominee or an agent. Thus a conduit company can normally not be regarded as the beneficial owner, though the formal owner of certain assets, it has very narrow powers which render it a mere fiduciary or an administrator acting on account of the interested parties (most likely the shareholders of the conduit company)
The comments made in the above mentioned report were included in the 2003 Commentary on the OECD Convention and led Professor Baker QC, in paragraph 10B -10.4 of his official commentary on the OECD Model Convention to state:
‘The essence of this Commentary is to explain that the ”beneficial ownership” limitation is intended to exclude:
(a) mere nominees or agents, who are not treated as owners of the income in their country of residence;
(b) any other conduit who though the formal owner of the income, has very narrow powers over the income which render the conduit a mere fiduciary or administrator of the income on behalf of the beneficial owner.
It is worth making the point that, as seems clear from this amended Commentary the mere fact that the recipient may be viewed as a conduit does not mean that it is not the beneficial owner.’
As a practical approach, one can ask whose income the dividends (interest/royalties) are in reality. One way to test this is to ask: what would happen if the recipient went bankrupt before paying over the income to the intended, ultimate recipient? If the ultimate recipient could claim the funds as its own, then the funds are properly regarded as already belonging to the ultimate recipient. If however, the ultimate recipient would simply be one of the creditors of the actual recipient (if even that), then the funds properly belong to the actual recipient.
The meaning of the term beneficial ownership was recently subject to the judgement of a UK court in the Indofood case. The subsequent published interpretation by HMRC to this decision is a good illustration of how HMRC will apply beneficial ownership to combat treaty shopping.
The case related to the interpretation of a loan note agreement between JP Morgan and the Indonesian based Indofood group. The Indonesian parent company issued a loan note to note holders via the use of a Mauritius finance SPV (“M SPV”). Under the loan agreement any withholding tax on interest would be for the account of Indofood. JP Morgan acted as the agent for the note holders. Based on the Indonesian-Mauritius double tax treaty the Indonesian withholding tax on the interest payments was reduced from 20% to 10%. The terms of the arrangement determined that if the Indonesian withholding tax went above 10% and no “reasonable measure” could be found to avoid the increase, then M SPV could redeem the loan notes.
Because the Indonesian government terminated the tax treaty with Mauritius, Indofood sought to initiate the get-out clause. JP Morgan argued that a Dutch SPV (“Newco”) could be used. The loan agreement was governed by English law and the dispute was brought before an English court, who was asked to rule on how an Indonesian tax court would interpret the meaning of beneficial ownership. The Court of Appeal held that Newco could not be considered to be the beneficial owner in the treaty sense.
Recently, the UK tax authorities (HMRC) issued a guidance note on its interpretation of the Indofood decision. Where a special purpose vehicle (SPV) has “very narrow powers over the income and its obligations to the bondholder mean that it is unlikely to enjoy the full privilege to directly benefit from the income”, it may not be the beneficial owner of the income. The guidance note contains a number of examples where the use of a finance SPV is accepted. However, finance structures that fall outside the scope of these examples may only be effective for UK tax purposes if approved by HMRC on a case by case basis. HMRC have also indicated that in the event the SPV is not considered as the beneficial owner and therefore is not entitled to double tax treaty benefits, they would apply, where applicable, the double tax treaty benefits of the State of residence of the (ultimate) shareholder of the SPV.
The general view is that the Indofood case has little relevance to UK tax law since the decision revolved to a large extent around Indonesian law. The decision does not add much to or change the meaning of “beneficial owner” as we know it from the interpretation given by the OECD in its various publications. Furthermore, the facts and circumstances in the Indofood case were such that it was indeed difficult to argue that M SPV or Newco could be considered as the beneficial owner. However, HMRC’s reaction to the Indofood decision and the issue of the guidance note indicates that it will challenge situations where – in HMRC’s view – there is ‘unacceptable’ treaty shopping.
Limitation on benefits provisions (US)
The limitation on benefits provisions are the most direct form of tools that can be used against treaty shopping. The extensive and complex nature of these rules as we currently know them, were introduced by the US when concluding bilateral treaties with other States. The purpose of these provisions is to ensure that the tax benefits granted by (effectively) the US on the basis of the tax treaty are restricted to the intended beneficiaries. As a general rule, the intended beneficiaries of US tax treaties are residents of the other State (A) with which the US has concluded the tax treaty. Therefore, residents of other States are excluded from the benefits granted under the tax treaty the US has concluded with State A. For example, this would apply in the situation where a resident of a third State (B)would use a company in State A merely to obtain the benefits granted under the US-State A tax treaty. This is particularly relevant if State B has not concluded a tax treaty with the US or when it does, the benefits under that treaty are less generous than the ones granted under the treaty the US has concluded with State A. Naturally, there can be valid commercial reasons for resident of State B to use a company in Sate A that receives income from the US. In these bona fide situations treaty shopping may not be considered to be the main reason for the structure and the limitation of benefits provisions usually would allow the treaty benefits to be granted.
Typically, the limitation on benefits provisions contain the following tests and derivative tests which will determine whether or not the benefits can be granted, such as:
Stock ownership test (a company claiming treaty benefits needs to be a so-called ‘qualified person’, meaning that it shares are owned by individuals resident in that State or other ‘qualified residents’)
Publicly traded test (the shares of the company claiming the treaty benefits are publicly traded or the company is a subsidiary of a publicly traded entity)
Base erosion test (less than 50% of the income of the company claiming treaty benefits is paid or accrued to persons who are not residents of either Contracting State)
Active business test (where the company does not satisfy the stock ownership/publicly traded tests treaty benefits may still be granted if the company is carrying on an active trade or business in its State of residence)
Headquarter company test (headquarter operations are not considered to constitute an active trade or business and treaty benefits will still be granted under certain conditions).
One would have thought that these limitation on benefits provisions provide the US with ample scope to fight treaty shopping. However, recently the Democrats have proposed new domestic legislation which effectively would ignore treaty shopping transactions and would apply the relevant tax treaty concluded by the US and the State where the ultimate beneficial owner of the company claiming treaty benefits is resident.
Certain tax treaties contain general or specific provisions that aim to prevent treaty shopping. Examples are the Netherlands-UK double tax treaty that contains specific anti-avoidance provisions with respect to dividend, interest and royalty income. An example of a general anti-treaty shopping provision can be found in the Protocol to the Israel-Switzerland double tax treaty.
A number of countries have embedded in their local laws provisions that provide that the benefits of tax treaties are not granted in situations where there is perceived misuse of the treaties. Even if the relevant tax treaty does not contain such anti-abuse provision, the treaty benefits can be denied on the basis of local laws. Germany for example, has recently tightened its domestic anti-treaty shopping clauses.
Under the new anti-avoidance legislation non-German holding companies need to satisfy stringent conditions in order to claim a reduction of the interest and/or dividend withholding tax rates as provided for under the relevant double taxation treaty or EU Directives. For example, the benefits, being the reduction in the withholding tax rates, are not available if:
The shareholders of the non-German holding company themselves would not be entitled to a refund or exemption of withholding tax if they held the German subsidiary directly; and,
there are no economic, legal or other non-tax driven reasons for the interposition of the intermediary holding company business (business purpose test); or
the foreign holding company does not perform an own business activity, which is the situation if it generates less than 10% of its gross receipts with active services (10% gross receipt test); or
the foreign company is not substantial due to an inadequate infrastructure and the employment of qualified and skilled personnel (substance test).
Particularly, the requirement to derive more than 10% of the gross revenues from their own business activities is new and it has to be seen whether such a test would be considered to be compatible with EU law. This requirement would not be satisfied if for example, the income of the non-German holding company only consists of income from its holding activities (dividends, capital gains on its shareholdings and interest on shareholders loans).
To pass the 10% income test, a possible solution for the non-German holding company might be to generate sufficient income from other activities such as active management services with regard to the holdings held and administration of licences and intellectual property and similar services. Please note, that it would seem that the 10% income threshold needs to be met every year. If in a year a significant dividend is distributed to the non-German shareholder, this might cause that the gross revenues from its active businesses will drop below the 10% threshold. It is unclear whether in such situation the holding company would be considered to have failed the test and we have to await further clarification on this point.
The anti-treaty shopping rules appear only to affect the reduction of withholding tax on dividend and interest payments as provided for under the relevant double tax treaty (or EU Directives) but not the other provisions of double tax treaties.
Germany is not the only jurisdiction in Europe that has incorporated anti-treaty shopping provisions in its domestic legislation. Other examples of countries that have incorporated domestic anti-treaty shopping provisions are for example Switzerland and Austria which do grant reduced rates or exemptions of withholding taxes, but only if the recipient of the relevant income has sufficient economic substance.
CFC regimes and compatibility with tax treaties
The main purpose of CFC regimes is to counter tax driven foreign investment and to avoid the tax basis erosion in the State of residence of the controlling shareholders (‘Home State’). Typically, when certain conditions are satisfied, the Home State imposes domestic taxation at the level of the controlling shareholder to the extent that income accrues to the CFC, either applying a deemed dividend or look-through approach. The target of CFC regimes is usually the passive and low-taxed income of the CFC as opposed to the trading profits. General justification for CFC regimes is that the resident shareholder has control over the CFC and its profit distribution and can determine that passive income subject to low levels of taxation can be retained within the CFC rather than being distributed and incur high domestic taxation.
The OECD and a majority of member States support the position that CFC regimes are compatible within the framework of the Convention. This position has been heavily criticised and tax authorities of various States and scholars hold different opinions. Furthermore, cases decided by national Supreme Courts of a number of States have resulted in different decisions. As a result there is no conclusive view that CFC rules are either considered to be compatible or incompatible with tax treaties.
In the Cadbury Schweppes case the European Court of Justice however, was recently asked whether the application of the UK CFC rules to low-taxed financial services income of Irish subsidiary was a justified hindrance of the freedom of establishment under the EU treaty. It ruled that the UK CFC rules were compatible but only to the extent they apply to wholly artificial arrangements intended to circumvent national law. No doubt further case law will be developed either by the European Court of Justice or by EU national courts to fine tune the meaning of wholly artificial arrangements. At least for the EU member States this is the first step of forming a single a consistent view with regards to CFC rules. Due to the absence of an International Court of Justice dealing with the interpretation of tax treaties, this is a luxury that is unfortunately not available to other OECD members when applying tax treaties.
A number of tax administrations are increasingly focusing on combating treaty shopping practices and may put pressure on the OECD to include in the Model Convention rules similar to the US limitation on benefits provisions. Furthermore, legislators may tighten existing domestic anti-treaty shopping provisions. Needless to say that these developments would make tax planning for cross border activities more challenging. It is therefore becoming more and more important that in tax planning, commercial reasons form the basis for choosing a particular structure and that each company in the structure has sufficient means (substance, office accommodation and personnel) to perform the tasks and duties it is supposed to undertake.