Focus On BEPS Action 6: Prevention of Tax Treaty Abuse
28 May, 2014
On March 14, 2014, the Organisation for Economic Cooperation and Development (OECD) published its Discussion Draft on Action 6 of the Base Erosion and Profit Shifting (BEPS) project, on preventing treaty abuse. However, as with many other aspects of the OECDs work in relation to BEPS, respondents have warned that the proposals threaten to punish innocent taxpayers and disrupt global investment flows.
In February 2013, the OECD released its preliminary BEPS report Addressing Base Erosion and Profit Shifting on the use of tax-efficient business structuring by multinationals to lower group corporate tax liability, as a first step to addressing the use of profit-shifting tax planning techniques by international businesses.
The report observed that due to imperfect interaction between nations' tax regimes, and their extensive networks of double tax agreements, the global tax system has failed to keep pace with the changing needs of the 21st century in terms of mitigating corporate tax avoidance. The study points out that these inadequacies have allowed multinationals to legitimately structure their tax affairs using profit-shifting arrangements to pay tax on their profits at rates as low as 5%, against the corporate tax rates of around 30% in place on fiscally immobile businesses in some OECD member states.
Then, on July 19, 2013, the OECD released its much anticipated BEPS Action Plan, which it claims provides a global roadmap that will allow governments to collect the tax revenue they need to serve their citizens while giving businesses the certainty they need to invest and grow.
Introduced at the G20 Finance Ministers meeting in Moscow last year, the Action Plan identifies 15 specific actions that will give governments the domestic and international instruments to prevent corporations from paying little or no taxes.
The OECD says that its Action Plan will develop a new set of standards to prevent double non-taxation, based on closer international co-operation to close gaps that, on paper, allow income to disappear for tax purposes by using multiple deductions for the same expense and treaty-shopping. It also proposes stronger rules on controlled foreign companies.
Action 6 Prevent Treaty Abuse
Action 6 proposes the development of model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances. Work will also be done, it says, to clarify that tax treaties are not intended to be used to generate double non-taxation. Additionally, tax policy considerations will be identified that countries will be urged to examine before deciding to enter into a tax treaty with another country.
A key element of this Action will be modifications to the definition of permanent establishment (PE) which the report says must be updated to prevent abuses. It is observed that in many countries, the interpretation of the treaty rules on agency-PE allows contracts for the sale of goods belonging to a foreign enterprise to be negotiated and concluded in a country by the sales force of a local subsidiary of that foreign enterprise without the profits from these sales being taxable to the same extent as they would be if the sales were made by a distributor.
In many cases, this has led enterprises to replace arrangements under which the local subsidiary traditionally acted as a distributor by commissionaire arrangements with a resulting shift of profits out of the country where the sales take place without a substantive change in the functions performed in that country, says the report. Similarly, MNEs may artificially fragment their operations among multiple group entities to qualify for the exceptions to PE status for preparatory and ancillary activities.
The OECDs work to prevent tax treaty abuse overlaps with its work on hybrid mismatch arrangements (Action 2). This Action proposes the development of model treaty provisions and recommendations regarding the design of domestic rules to neutralise the effect of hybrid instruments and entities on a jurisdictions tax base. This may include: (i) changes to the OECD Model Tax Convention to ensure that hybrid instruments and entities (as well as dual resident entities) are not used to obtain the benefits of treaties unduly; (ii) domestic law provisions that prevent exemption or non-recognition for payments that are deductible by the payor; (iii) domestic law provisions that deny a deduction for a payment that is not includible in income by the recipient (and is not subject to taxation under controlled foreign company (CFC) or similar rules); (iv) domestic law provisions that deny a deduction for a payment that is also deductible in another jurisdiction; and (v) where necessary, guidance on co-ordination or tie-breaker rules if more than one country seeks to apply such rules to a transaction or structure.
Special attention should be given to the interaction between possible changes to domestic law and the provisions of the OECD Model Tax Convention, says the report. This work will be co-ordinated with the work on interest expense deduction limitations, the work on CFC rules, and the work on treaty shopping.
Action 6 Discussion Draft
The OECD's 31-page discussion draft focuses on three areas in particular. It seeks to develop treaty and domestic law provisions to deny treaty benefits in inappropriate circumstances; it seeks to make clear that tax treaty benefits should not create double non-taxation; and discusses tax policy considerations that Governments should check before agreeing to a tax treaty.
The Draft discusses scenarios potentially involving treaty abuse, in particular involving the use of treaties to circumvent tax on dividends, and otherwise artificially re-route payments to achieve a tax advantage. A distinction is proposed, in these examples, between what should be considered to be abusive and non-abusive transactions.
The OECD proposes to modify the preamble to the OECD Model Tax Convention, to highlight the need to negotiate treaties without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance. It would include wording warning against the negotiation of treaties that enable treaty shopping through the provision of benefits to residents of third states. Further to this, the OECD proposes to generalize the limitation-on-benefits (LOB) provisions provided for by the US Model, and to a lesser extent, by some treaties concluded by Japan and India.
Interestingly, the discussion draft includes an idea for a tax treaty General Anti-Avoidance Rule (GAAR). The proposed treaty GAAR has been drafted as follows:
"Notwithstanding the other provisions of this Convention, a benefit under this Convention shall not be granted in respect of an item of income if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the main purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of this Convention."
The OECD has already published a 14-page supplement to its 79-page draft on Action 2, on March 19 on the tax treaty aspects of neutralizing hybrid mismatch arrangements, which focuses on dual resident entities and on "wholly or partly fiscally transparent" persons.
In order to tackle dual residency concerns, the OECD proposes revising Article 4(3) of the Model Tax Convention. This would involve a tie-breaker rule for legal persons, which would be based on a mutual agreement rather than on the place of effective management. If there is no such agreement, treaty benefits may be denied.
Regarding fiscally transparent persons, the proposed changes will affect Article 1 of the Model Tax Convention. It will introduce a second paragraph drafted as follows:
For the purposes of this Convention, income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting State shall be considered to be income of a resident of a Contracting State but only to the extent that the income is treated, for purposes of taxation by that State, as the income of a resident of that State. In no case shall the provisions of this paragraph be construed so as to restrict in any way a Contracting State's right to tax the residents of that State.
Criticism of the Anti-Treaty Abuse Proposals
On April 11, 2014, the OECD published comments received from various stakeholders concerning its Discussion Draft on tackling treaty abuse. However, in a similar vein to the other BEPS discussion drafts, including on the challenges of taxing the digital economy, on neutralising the effects of hybrid mismatch arrangements and transfer pricing arrangements, it is hard to find a positive comment.
Many of the respondents concerns are centred on the fact that the new measures, if put in place, would seriously reduce the ability of cross-border investors to claim legitimate treaty benefits, which in turn could have a negative impact on the global economy by reducing international trade and investment.
Mary C Bennett of Baker & McKenzie LLP, Counsel to the Association of Global Custodians, stated: "Our primary concern with the Discussion Draft is that its proposed rules to prevent the granting of tax treaty benefits in inappropriate circumstances will adversely affect the majority of taxpayers legitimately seeking treaty benefits for their genuine commercial and investment transactions."
"We are concerned that the proposals will lead to uncertainty and [a] lack of clarity, thereby disrupting the process for obtaining legitimate treaty relief for high volume cross-border investment flows and undermining the very purpose of treaties," Bennett added.
In a separate response, Will Morris of the Business and Industry Advisory Committee (BIAC) to the OECD warned that: "Restricting the application of treaty protection should be approached with considerable caution lest it result in a heavy cost for international trade and be contrary to the aims of the OECD." He emphasized that: "Such restriction should only occur in clear cases of abuse."
"It is important that there should be protection for bona fide commercial arrangements. Where tax incentives are made available, and such incentives are not judged 'harmful' on objective criteria, then taking advantage of such incentives should not be seen as abusive and specifically in terms of Action 6 not as treaty abuse," he concluded.
Commentators also expressed concerns about the uncertainty that the introduction of an LOB article may bring to the taxpayer and tax administrations. Richard Middleton of Association for Financial Markets in Europe, and Sarah Wulff-Cochrane, Director of Policy at British Bankers' Association, warned that: "Such uncertainty may erode the benefits that double tax agreements provide with respect to cross-border trade and therefore potentially deny treaty benefits to those who would otherwise be entitled to them.
For its part, the Chartered Institute of Taxation reminded the OECD that "the benefits arising from tax treaties in facilitating international trade and investment should not be forgotten, and facilitating international trade and investment should continue to be a fundamental aim of the work in this area."
The United States Council for International Business (USCIB) was particularly scathing about certain aspects of the discussion draft, and warned that the proposals do not go far enough to ensure predictable and certain tax treatment for law-abiding multinationals. It also expressed concerns that the review might make tax treaty benefits more challenging to obtain.
Reiterating that the BEPS Action Plan must bring about certainty regarding international tax rules, the letter says the recommendations on access to treaty benefits in the discussion draft are "overly restrictive," and warns against the introduction of "vague and subjective anti-abuse standards."
The letter, written by the Taxation Committee Chair of the USCIB, recommends:
- The rejection of "overly restrictive" standards proposed in the 'Entitlement to Benefits' article, which would mirror the US version of Limitation on Benefits (LOB);
- The rejection of substantive main purpose or general anti-avoidance treaty solutions, and instead either the use of specific treaty measures to address concerns about conduit financing, or, a direction to countries to revisit their domestic law anti-abuse rules to assure that they are: effective in today's environment; focused on identified abuses; administrable; and do not impede legitimate business and investment activities;
- A presumption towards the passing of the "main purpose test" by enterprises where requisite criteria for treaty benefits under the Limitation of Benefits article are met;
- A provision that, if the decision is made to retain a main purpose test, enterprises that meet any of the other criteria for eligibility for the benefits of the treaty under the LOB article should be presumed not to fail the main purpose test unless the relevant Competent Authority establishes by clear and convincing evidence that the test should apply, providing clearly that such evidence cannot take into account the status of the owners of the enterprise as non-residents of the enterprise's state of residence, and that persons denied benefits should have access to a Mutual Agreement Procedure with binding arbitration; and
- In the course of endorsing effective anti-abuse measures, the provision of a clear mandate for countries to adhere to the fundamental precept already recognized in the Commentaries that, consistent with the goal of promoting bilateral trade and investment through establishing rules that provide the greatest degree of certainty and predictability for bona fide beneficiaries of tax treaties, rules that create subjectivity and uncertainty, or that rely on cumbersome pre-clearance procedures straining the resources of tax administrators are to be avoided.
The OECD plans, by September 2014, to issue recommendations regarding the design of domestic and tax treaty measures to neutralise the effects of hybrid mismatch arrangements, both from a domestic and treaty law perspective. It also plans to issue recommendations regarding the design of domestic and tax treaty measures to prevent abuse of tax treaties by the same deadline. The publication of these recommendations will coincide with five other of the OECDs BEPS deliverables, including an in-depth report identifying tax challenges raised by the digital economy and the necessary actions to address them; the finalisation of the review of member country regimes in order to counter harmful tax practices more effectively; changes to the transfer pricing rules in relation to intangibles; changes to the transfer pricing rules in relation to documentation requirements; a report on the development of a multilateral instrument to implement the measures developed in the course of the work on BEPS.
A further eight BEPS goals are due to be achieved by September 2015, with the project timetabled to be concluded by December 2015.
As can be gleaned from the responses of taxpayers and stakeholders so far, many are highly sceptical that the OECDs overall goal, which will require nations to throw out and replace some firmly entrenched principles of taxation in a coordinated manner, is achievable in such a relatively short space of time without a significant amount of collateral damage. With regards to tax treaties, this could mean that some 3,000 bilateral tax agreements will have to be renegotiated, and it doesnt take an expert in this field to conclude that this could take many years, if indeed it is feasible in the first place. The result of a multi-speed BEPS response to the BEPS Action Plan could therefore be self-defeating if the result is a more uneven global tax playing field than is the case at present, leading to a more uncertain tax environment for multinational companies and international investors which in turn could reduce levels of investment and economic growth. These are concerns that the OECD and its members have yet to adequately address.
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