In the final report on BEPS Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, the OECD alleges that multinational corporations (MNCs) deprive countries of tax revenues by claiming treaty benefits in situations where these benefits were not intended to be granted, such as by interposing holding and conduit finance companies. The OECD intends to put an end to inappropriate and abusive use of tax treaties through i) certain amendments to the OECD Model Treaty; ii) an amendment to the title and preamble of double tax treaties; and iii) outlining certain tax policy considerations for countries to reflect upon before entering into tax treaties.
It has been a long-held belief that corporations should be free to structure their affairs efficiently, as long as their arrangements are not artificial and abusive. This was well articulated in the 1929 case of Ayrshire Pullman Motor Services and Ritchie v IRC, where Lord Clyde said:
No man in this country is under the smallest obligation, moral or other, so as to arrange his legal relations to his business or his property as to enable the Inland Revenue to put the largest possible shovel into his stores.
Much of the debate will revolve around the meaning of the word 'abusive'. Is tax planning involving the use of tax treaties, principal companies, holding companies, finance companies and special purpose vehicles (SPVs) still allowed?
The fact that the OECD's final report is not very final makes it difficult to go into much detail, other than the new principal purpose test (PPT) provision. In order to fill in the blanks left by the OECD, this article provides further guidance on how to apply the PPT provision in practice, starting with a short economic context, as this is critical for a proper understanding of the issues in play.
Equity and debt funding should be better balanced
Since the beginning of modern corporate income tax (CIT) systems and the start of double taxation treaties, a discrepancy has been built into these systems in terms of the tax treatment of equity and debt. In a cross-border context, tax treaties could have provided a solution and could have restored the balance. Since dividends were distributed out of after-tax income, withholding tax (WHT) on dividends should preferably be zero. On the other hand, interest was typically allowed as a business expense in the source country. It would therefore restore the balance in the source country if payment of interest to an overseas lender incurs a fairly high level of WHT, say 20%. This way, there would be no incentive to fund overseas operations with (excessive) debt, there would be no reason for deferral, nor for conduit companies, since all foreign investors would incur the same high WHT in the source country.
Optimum allocation of economic activity
Economic theory explains that economic activity should take place where it is done most efficiently. In a world without borders, tariffs and WHT, we would arrive at the most efficient distribution of production and economic activity across the globe. Purely through the mechanism of price effects we would reach this state where our total combined global income is maximised. Double taxation creates obstacles that lead to a suboptimal distribution of economic activity, thereby slowing economic progress and reducing global income. The proposals in this final report will most definitely increase double taxation.
An incomplete report
The OECD has a reputation for solid research and argumentation. What is striking about the final report on BEPS Action 6, and atypical of the OECD as we know it, is:
- the lack of proof that MNCs pay proportionally less tax than small and medium size enterprises (SMEs);
- the lack of consideration for and research into the balance between BEPS opportunities resulting from cross-border activities on one hand and inefficiencies (no offset for losses, non-deductible costs, non-creditable WHT, among others) due to cross-border operations on the other hand; and
- the lack of an impact analysis of the BEPS proposals on global trade.
After all, this is a report issued by the Organisation for Economic Cooperation and Development.
Principal purpose test (PPT)
Perhaps the most important and most hotly debated part of the report relates to the PPT. The final report on Action 6 leaves many questions unanswered. Most of the examples are very obvious and not instructive. This is an indication of the limited applicability of the PPT. Few examples provide useful insight, and where they enter the more interesting shades of grey, they reach the wrong conclusion. The analysis below attempts to answer some open questions and to provide better guidance under the PPT.
In the report, the PPT is article X(7) of the OECD Model tax convention and reads 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 or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal 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.
Paragraph 5 of the limitation on benefits (LOB) test contains a different variation of PPT under the competent authority's discretionary relief provision. See also comment 64 of the final report.
In tax law, a main purpose test or PPT is an established test to prevent abuse of a legal provision. Many countries have similar tests in their domestic legislation, or apply a general anti abuse doctrine which is similar to the test proposed by the OECD. EU law has also adopted various provisions including a similar test and that operate as an anti-abuse rule. In the Cadbury Schweppes case, the European Court of Justice (ECJ) restricted the scope of specific anti-abuse measures to wholly artificial arrangements. Genuine business activities are protected by the EU's fundamental freedom rights and will need to be respected.
The OECD's PPT sounds rather ominous upon first reading, but should be read against the backdrop of a long list of case law in many OECD countries, and against the guiding principle of paragraph 9.5 of the Commentary on article 1 of the OECD Model Treaty:
A guiding principle is that the benefits of a convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions.
In fact, article X(7) is the codification of the concept of 'fraus conventionis' or abuse of law in an international context.
Many anti-abuse tests are part of the same family, but there are some interesting differences. First of all, the older tests refer to the "sole purpose" and the "main purpose", whereas article X(7) speaks of "one of the principal purposes". Apparently, the OECD intends to lower the bar and to make it easier for tax authorities to test the behavior of tax payers against the objective test. This has, however, no effect other than more menacing semantics, since all these tests end with the same objective test as the ultimate test. A second difference is that article X(7) provides a main rule and an exception to the main rule, instead of two tests of equal standing. Again, the optical effect is more threatening, but the final test is still the same.
A common feature of all these tests is that they first look at the purpose of entering into a transaction. This transaction needs to be connected with the actions of a person, typically the person claiming treaty benefits. Usually this involves an analysis not only of the apparent purpose of his action, but also of any ulterior objectives or motives of a taxpayer. This is commonly referred to as the subjective test. The outcome of this analysis is tested against the object and purpose of the relevant treaty provision (the objective test). The meaning of "object and purpose", ("ziel und zweck", "doel en strekking" or "l'objet et à la finalité"), can sometimes cause confusion.
The "object" refers to the literal meaning of the relevant provision. To understand the "purpose", we need to look at the spirit of the law (Finalursache, causa finalis, strekking, la finalité).
As a general rule, treaty provisions aim to award a local tax benefit to a qualified resident of the other country (the objective). The source state steps back (provides a tax benefit) in order to entice investors and entrepreneurs of the other state to visit their shores (the purpose).
EU guidance on PPT proposed by BEPS Action 6
Based on EU law it was to be expected that the EU would require anti-abuse provisions to be in line with existing EU law and case law. For this reason, the European Commission (EC) has issued a guidance on January 28 2016 with the following recommendation:
Where member states, in tax treaties which they conclude among themselves or with third countries, include a principal purpose test-based general anti-avoidance rule in application of the template provided for in the OECD Model Tax Convention, member states are encouraged to insert in them the following modification:
"Notwithstanding the other provisions of this Convention, a benefit under this Convention shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that it reflects a genuine economic activity or that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of this Convention."
In other words, for EU countries the effect of the PPT proposal has been reduced to its legitimate proportions, as genuine economic activities will have to be respected.
The taxpayer's purpose
An abusive purpose must be attributed to a person in order to be meaningful. From a legal perspective, it would be problematic to deny a certain treaty benefit on the grounds of another person's abusive purpose. Tax law has not embraced a group concept; each company is dealt with individually. In other words, for the recipient of income to be denied treaty protection, it must be demonstrated that the recipient was party to an arrangement that had an abusive purpose. Merely being an associated enterprise does not satisfy that threshold. The objective of the recipient of the income must be assessed separate from possible motives of associated enterprises. If the recipient of the income has a clear commercial motive, grounded in its long term business plan, and was not aiming to realise an incidental benefit and is not party to a broader abusive arrangement, it seems extremely unlikely that treaty protection can be denied on the basis of another entity's abusive purpose.
A genuine holding or group finance company may be established in a well-known financial centre. Provided this company has sufficient local substance to manage its assets, operations and associated risks, and notwithstanding that its management acts in close coordination with senior group management, they remain sufficiently autonomous. Such a company is acting in the ordinary course of its business; it is arguably not considered to have as one of its principal purposes the pursuit of foreign treaty benefits, and even if that were the case, such pursuit would be considered in accordance with object and purpose of the relevant treaty benefits. Consequently, such a company should be able to rely on the tax treaties concluded by its country of residency and tax benefits offered by the treaty partners.
In a way, the analysis boils down to what would remain in a 'world without tax'. Genuine holding companies and genuine group finance companies would still exist as they have a real economic function. Conduit companies, however, that lack a real economic function and carry no material risks, may not survive in a world without tax. Consequently, treaty claims from these companies may be in jeopardy under the OECD's PPT, assuming the abusive purpose of their 'principal' can be attributed to the conduit company, which is no small legal step.
Limitation on benefits (LOB) rule is not yet finished
With the US being the biggest proponent of an LOB rule, the OECD is not able to proceed with final suggestions for its LOB rule as part of the rules to combat inappropriate treaty shopping under BEPS Action 6, as long as the United States has not finalised the work on its new LOB rule included in the US model tax treaty. The new version of the US LOB rule was released for public comment in May 2015, and was published on February 17 2016.
Active conduct of a business
The draft proposed LOB rule not only accords treaty protection to qualified treaty residents, but also to residents involved in the 'active conduct of a business' (ACB rule). To qualify under the ACB rule, the foreign income must be derived in connection with, or should be incidental to the business of the recipient of the income, and the latter business should be significant in relation to the business carried on in the foreign country.
Disappointingly, the OECD has resolved that headquarter companies do not qualify under the 'active conduct of a business' provision in the LOB rule published as part of BEPS Action 6. The commentary explains this with the argument that headquarter companies "manage investments", as if it is a passive activity. In reality, headquarter companies provide active strategic and operational support to the underlying businesses of their subsidiaries. Hardly a passive 'investment management' activity. As the OECD's comment is so detached from reality, it leaves the reader wondering if this is not politically inspired. (Interestingly, the recently published US Model treaty does allow treaty relief for HQ companies that exercise primary management and control functions).
In any event, it will result in double taxation on income that has already been taxed at operating company level (and triple taxation if ultimate shareholder taxation is included). Given the commentary, it is also unlikely that an HQ company can qualify for treaty relief via the proposed LOB's PPT safety net, included in the discretionary relief provision (paragraph 5). This means that intermediate holding companies do not qualify for treaty relief if there is no significant local business. We wonder why the rules are drafted such that intermediate holding companies must be established in a large economy.
Smaller countries should not adopt the rules proposed by Action 6 (via the multilateral instrument of Action 15 or otherwise), as it will result in a brain drain and will exclude them from attracting higher tier corporate management teams. This could be resolved by considering business operations within a broader trade union. Moreover, it is probably illegal for an EU country to include the proposed provision in a tax treaty.
Political or economic desirability
It is a legitimate question to ask if the world should be longing for more treaty anti-abuse rules. Judging from the current media coverage on alleged inappropriate behaviour of MNCs, one would be tempted to conclude that at least from one corner of the political arena there is indeed a loud demand for stricter rules with respect to cross-border holding and financing structures. The OECD seems to provide these stricter rules by introducing this ominous-looking PPT, by stressing the first part of the test (one of the principal purposes) and omitting to explain the much more restrictive nature (for the tax authorities) of the second part (in accordance with object and purpose of the relevant treaty provision).
There is a negative feedback loop of incorrect, incomplete and mostly misleading information about tax planning by MNCs between mainstream media, politicians and public. Given the origin of some of this information, world leaders would be wise not to lean too much towards this political sentiment. Instead, they should give prevalence to the urgent need for economic growth and the effect that additional trade and investment barriers will have on global trade and investment.
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Helmar Klink is an international tax partner based in Amsterdam, the Netherlands. After graduating from law school he completed a master's degree in economics and started working for Dutch tax law firm Moret Gudde Brinkman, a member firm of Arthur Young at the time.
His next 15 years were mostly spent overseas: he worked the Dutch desk in Paris for four years and in New York for six years. Since his return to The Netherlands in 2002, Helmar has shifted his focus to emerging markets in Asia, where he has hosted many of EY's think tanks. His clients include governments, sovereign wealth funds, multinational corporations, private equity and real estate funds.
Two of his other areas of expertise are Curaçao, where he functioned as treaty negotiator, and the sustainability of the Euro. Helmar leads EY's Euro consulting team, combining macro-economic, legal and tax aspects). Helmar is also a member of the International Tax Committee of the Dutch Tax Bar Association (NOB).
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