Tax Policy Bulletin Tax Insights from International Tax Services

OECD Report on Action 6 – Treaty Abuse

22 September 2014

In brief The OECD published a discussion draft in March 2014 on proposals for addressing perceived abuse of tax treaties. The draft recommended extensive changes to the OECD Model Treaty together with suggested domestic law provisions targeted at treaty abuse or abuse of domestic law where the abuse involves application of treaty benefits. The discussion draft also proposed a change to the preamble of tax treaties to clarify that tax treaties are not designed to create double non-taxation and included potential tax policy issues that countries might consider in deciding whether to enter into a tax treaty. A focal point of the discussion draft was the proposal for a US-style limitation on benefits article (LoB) to provide an objective basis for entitlement to treaty benefits for companies with a nexus in the resident country as well as a subjective main purpose / anti-abuse rule within the LOB article. In lieu of this singular combined LoB/Main Purpose Test approach, the OECD report on Action 6 now proposes a “minimum level of protection” to prevent treaty abuse, suggesting two alternatives to the combined approach that treaty partners may consider. Significantly, the LoB now includes a “derivative benefits test” provision allowing certain entities owned by residents of other States to obtain treaty benefits if these residents would have obtained the same benefits had they invested directly.

While the OECD report on Action 6 addresses some of the problematic provisions identified by stakeholders during the initial comment period, serious concerns still remain. Fortunately, the report recognizes that further work is required on the precise contents of the Model provisions to prevent unnecessary obstacles to cross-border business. Accordingly, the report states that the Model provisions and related Commentary should be considered as drafts subject to improvement before their final release in 2015.

In detail filtering income through a assumed to not have been treaty-resident intermediary, established or maintained for Entitlement to Benefits such as a company organized a principal purpose of giving article: overly restrictive in a treaty-qualified country. third country residents access standards still prevent To combat these abuses, the to the treaty. As a general clarity and predictability U.S.-style LoB seeks to matter, the various tests of The OECD proposed to qualify resident companies the U.S. LoB aim to carry out include a U.S.-style LoB in its only where the resident meets this purpose. However, Model Convention. one of several alternative certain provisions in the U.S. Generally, the U.S.-style LoB tests intended to establish LoB are unnecessarily targets abuses where a non- that the resident company restrictive and do not further treaty resident improperly has sufficient nexus to its the stated policy. Serious accesses treaty benefits by country of residence to be concerns arise to the extent

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that the OECD Model companies present a low risk of being made to persons other than the recommendations are modelled after used to extend treaty benefits to third aforementioned Qualified Persons those U.S. LoB provisions. country residents. must be less than 50 percent of the company’s gross income. However, Like the U.S. LoB, the OECD Model These additional restrictions were arm’s length payments will not count sets forth multiple tests, at least one of developed in U.S. LoBs to address the against the 50 percent threshold. The which a resident company must issue of inverting companies, a report does not discuss why satisfy to be considered generally domestic policy concern better acceptable owners of the tested eligible for the benefits of the treaty. addressed under domestic law. company must have the same country The first, known as the Publicly The OECD Model LoB also allows of residence as the tested company. Traded Company Test (the “PTC Historically, the standard US LoB Test”), entitles a company to treaty certain subsidiaries of publicly traded companies to qualify (the “SPTC treated Qualified Persons resident in benefits if its principal class of shares either country to be treated as good is regularly traded on at least one Test”). A company that is at least 50 percent owned (by vote and value), owners. The US changed its policy to recognized stock exchange. One of the local ownership pursuant to domestic following two additional requirements directly or indirectly by five or fewer companies that satisfy the PTC Test policy concerns about inverted must also be satisfied: (1) the shares companies. However, a company are primarily traded on one or more will qualify for benefits. The discussion draft required that, in the wholly owned by residents of the two exchanges located in the company’s Contracting States, and meeting the country of residence, or (2) the case of indirect ownership, each intermediate owner in a chain be Base Erosion Test, cannot be a vehicle company’s primary place of for providing treaty benefits to management is its residence country. residents of one of the Contracting States, as opposed to only testing the residents of third countries. As with Many companies will be challenged to the SPTC Test, the report includes in meet either of these alternative tests. subsidiary’s ultimate owner. That restriction remains but is bracketed to brackets the requirement that all Companies typically list their shares intermediate entities in a chain of on a regional exchange that will reflect the fact that there was not a consensus that the intermediate ownership be residents of one of the provide the best access to the capital Contracting States, creating an markets, which often will not be a ownership rule should apply. Such a requirement would be an impediment obstacle to companies’ ability to meet local exchange but, rather, an the Ownership-Base Erosion Test and exchange in the same economic to multinational enterprises which often have hundreds of affiliates set again raising EU law concerns. A region. In addition, the local exchange company can also qualify for benefits requirement may well violate EU law. up in a variety of countries for sound business reasons. It would also if under the proposed LoB for certain The alternative test of place of items of income if it is engaged in the management will be a challenge for maintained in our view be challengeable under EU law. The active conduct of a trade or business companies with decentralized in the Contracting State of which it is management, particularly in light of report provides no explanation for the rule’s inclusion and the anti-treaty resident and the income earned in the the guidance in the proposed other country is incidental or Commentary that would require shopping rationale for its inclusion is not clear. connected to that trade or business. If analysis of executives employed in the tested company conducts business affiliated companies. The report’s Under the proposed Ownership-Base in the source state or the income is commentary states that these Erosion Test, a company can qualify received from an affiliated company, additional provisions are necessary for benefits if it satisfies the following the activities conducted in the because, while a publicly-traded two requirements. First, for the company’s country of residence must company may be technically a majority of the tax year, the company also be substantial in relation to the resident in a given country, it may not must be at least 50 percent owned activities conducted in the country have a sufficient relationship with the (directly or indirectly) by certain where the income arises. Finally, if a country to justify allowing the Qualified Persons with the same company manages investments for its company to obtain benefits. However, residence country as the tested own account, these activities do not this position runs counter to long- company (e.g., resident individuals, or amount to a “trade or business” unless standing policy, found in the a resident company passing the PTC they are in the nature of banking, Commentaries, that the PTC test Test). Second (the Base Erosion Test), insurance or securities and are carried recognizes that publicly traded the amount of deductible payments on by such a company.

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In contrast to the discussion draft, the unintentional. The absence of a treaties for domestic policy reasons report now includes a Derivative Derivative Benefits article would as add inappropriate further Benefits article, substantially previously mentioned also raise EU restrictions on qualification under improving upon the discussion draft. law issues. the LoB. However, the test appears in brackets suggesting the possibility that there If a company is unable to avail itself of  It remains unclear how collective will not be a consensus for its treaty benefits through one of the investment vehicles (“CIVs”) and methods discussed above, the draft inclusion in treaties that choose to use other investment entities will LoB provides that the company can the LoB. The proposed Derivative access treaty benefits as the LoB apply for a discretionary grant of Benefits test allows treaty benefits for provisions are not designed to deal benefits with the relevant source a company that meets two with such entities. requirements. First, the tested country’s competent authority. While company must be at least 95 percent a discretionary grant of benefits  While addressing certain owned (directly or indirectly) by no provision is a critical component to an procedures associated with a LoB, the experience in the United more than seven persons who are discretionary grant of benefits, the States is that applying for Equivalent Beneficiaries. In brief, an report does not include a mandate discretionary benefits has been a Equivalent Beneficiary includes to expedite the lengthy and certain qualified residents of either cumbersome, lengthy and costly process for both the applicant and the cumbersome process of applying Contracting State or a resident of a for and obtaining the discretionary third jurisdiction that qualifies for governmental agency charged with grant of benefits. benefits under a comprehensive granting the benefits. The report, income tax treaty between the owner’s unfortunately, does not include a The report clearly demonstrates that country of residence and the source mandate for countries to expedite the OECD responded to comments state and, in the case of dividends, these processes, nor does it include provided by stakeholders. Given the interest, or royalties, would have any ideas for potential improvements. significant concerns that remain qualified for equivalent or better In summary, while the report outstanding, it will be critical for any treaty benefits under that treaty. substantially improves upon the and all stakeholders to provide the Second, the amount of deductible discussion draft reflecting the OECD’s OECD with further comments and payments (excluding certain arm’s responsiveness to comments feedback on the report on Action 6 to length payments made in the ordinary submitted by stakeholders, numerous ensure that these concerns are course of business) made to non- concerns remain, including: properly addressed. Equivalent Beneficiaries must be less than 50 percent of the tested  The requirement for intermediate Principal Purpose Test- subjectivity and uncertainty company’s gross income. The policy owners to be “qualified” residents concerns justification for a derivative benefits in many of the LoB tests (i.e., the The PPT is identical to the previous provision is obvious: no abuse occurs SPTC Test, the Ownership-Base March 2014 version except with the where an investor could obtain the Erosion Test, and the Derivative same treaty benefits by investing in substitution of "principal" purpose for Benefits Test) means that many the source-State directly, as it would "main" purpose regarding obtaining a resident companies that, by any through an intermediary. As currently treaty benefit, unless granting that drafted, the proposed Derivative objective standard, should be benefit would be in accordance with Benefits test also requires found to meet the nexus the object and purpose of the relevant intermediate owners in a chain to be requirement and not be considered provisions of the treaty in question. residents of the Contracting States. treaty shopping will be denied The report makes clear that the PPT Unlike the subsidiaries of public access to treaty benefits. would be incorporated into the treaty companies and the Ownership-Base  Limitations on the Publicly Traded itself, whilst noting that some states Erosion tests, the questionable may have a purpose based general restriction on intermediate owners Test and the Ownership-Base anti-avoidance rule (GAAR) in does not appear in brackets even Erosion Test that replicate domestic law that is capable of though it is most likely to be an restrictions found in US tax applying to transactions involving the obstacle to qualification under the treaties that are not relevant to application of tax treaties. Derivative Benefits Test. We surmise access to treaties by third country Accordingly, the proposed PPT would the absence of brackets was residents but are present in the US assist those states whose constitution

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might not permit a domestic law Explanation to the treaty, the US effective management tie-breaker, GAAR override of tax treaties. Treasury stated that it would apply the and conduit arrangement standard in In our view, it remains arguable that accordance with its domestic anti-  situations where the State of the PPT saving provision, in referring conduit rules. residence exempts the income of to granting a treaty benefit in permanent establishments (PEs) accordance with the object and Additional items situated in third States and where purpose of the relevant provisions of The report continues to recommend shares, debt-claims, rights or the treaty, may not go far enough as that treaties include in their title and property are transferred to PEs set regards the EU law requirement for an preamble a clear statement that the up in countries that do not tax such anti-avoidance rule to allow a Contracting States, when entering into income or offer preferential taxpayer to commercially justify their a treaty, intend to avoid creating treatment to that income, where it conduct. This is less clear however in opportunities for non-taxation or is recommended that to fully the context of a tax treaty than as reduced taxation through tax evasion regards a domestic law anti-avoidance or avoidance, including through treaty access treaty benefits the income provision. shopping arrangements which the must be taxed at a rate that is at proposed preamble defines as least 60% of the rate that would The report confirms that if both the “arrangements aimed at obtaining have applied absent the residence LoB and PPT are adopted, the PPT reliefs provided in this Convention for country tax exemption of the PE. supplements and does not restrict the the indirect benefit of residents of operation of the LoB provision. The report refers to the splitting up of third States.” contracts with respect to the 12 month The report gives a number of The report also includes threshold of Article 5(3) and says this examples of where treaty shopping recommendations to deal with will be dealt with in the Action 7 work e.g., for a lower rate of withholding tax on PEs. on interest or on dividends via a  certain dividend transfer situations usufruct would be combatted by the seeking to access the (normally The report also proposes new Model new PPT, whereas locating a new 5%) lower treaty rate of dividend Treaty Commentary language to make manufacturing plant in a state with a clear that domestic anti-abuse withholding tax by introducing the lower dividend withholding tax rate or provisions such as thin capitalisation, requirement of a 365 day a CIV investing part of its portfolio in exit tax or dividend stripping rules are a state with a lower dividend continuous holding of the requisite not necessarily over-ridden by tax withholding tax rate or an investor percentage ownership into Article treaties. The report does acknowledge increasing their shareholding to 10(2)(a); that where the application of qualify for a lower rate of dividend  transactions designed to provisions of domestic law and those withholding tax are not considered to of tax treaties produce conflicting circumvent the application of the run afoul of the PPT. However, the results, the provisions of tax treaties treaty rule that allows source guidance proposed in the are intended to prevail, citing the Commentaries leaves large gaps in taxation of real estate companies Vienna Convention. It then suggests illustrating the application of the by introducing new wording into that nonetheless each case must be standards, leaving room for Article 13(4) to extend to analysed based on its own considerable uncertainty, predictable partnership interests or trusts and circumstances with respect to the controversy, and inconsistency in how include a 365 day testing period for relevant tax treaty (and, although not those standards will be applied by triggering the 50% of value from expressly mentioned, the various tax authorities. real estate threshold at any time in constitutions of the two treaty partner States).Domestic anti-abuse rules may Curiously, the report’s definition of a that period; however be over-ridden where the conduit arrangement includes  situations where an entity is a new PPT is not triggered. But for precisely the same principal purpose resident of two Contracting States GAARs the report suggests this will test that it is understood the US where a competent authority tie- seldom be the case. refuses to contemplate at treaty level. breaker is recommended as the The income tax treaty between the The report includes proposed Model default wording in Article 4(3) but United States and the United Treaty Commentary wording to clarify States retain the right to use the Kingdom contains a conduit that a treaty does not affect the arrangement test. In its Technical

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taxation by a State of its own (members of diplomatic missions and contents of the model provisions and residents, except with respect to consular posts). related Commentary and in particular benefits granted under Article 7(3) the LoB rule, and on the policy (income attributable to a PE) , Article Lastly, the report updates the Model considerations relevant to treaty 9(2) (correlative adjustments for Treaty Commentary guidance on entitlement of CIVs and non-CIV transfer pricing) and Article 19 when a State should enter into a tax funds. Accordingly, the Model (government service), Article 20 treaty with another State. provisions and related Commentary (students), Article 23 (double tax The takeaway should be considered as drafts subject relief), Article 24 (non- to improvement before their final discrimination), Article 25 (mutual The report as noted above states that adoption in September 2015. agreement procedure) & Article 28 further work is required on the precise

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Richard Collier, London Stef van Weeghel, Amsterdam Phil Greenfield, London +44 (0) 20 7212 3395 +31 (0) 88 7926 763 +44 (0) 20 7212 6047 [email protected] [email protected] [email protected]

Pam Olson, Washington +1 (202) 414 1401 [email protected]

Prevent treaty abuse Peter Cussons, London Steve Nauheim, Washington David Swenson, Washington +44 (0) 20 7804 5260 +1 (202) 414 1524 +1 (202) 414 4650 [email protected] [email protected] [email protected]

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