BEPS Action 6 – Treaty Abuse

BEPS Action 6 identifies treaty shopping as one of the most important sources of BEPS concerns. Countries that do not have anti-abuse provisions in their tax treaties are exposed to lower tax revenues. Therefore it has been agreed between countries to include anti-abuse provisions in their tax treaties, including a minimum standard to counter treaty shopping. It is also agreed that some flexibility in the implementation of the minimum standard is required. This is to allow for each country’s specifics and for renegotiation of bilateral conventions.

With these agreements reached under BEPS Action 6 countries are now repairing holes in their treaties that allowed for treaty shopping by implementing safeguards.

The recommendations comprise of three sections that will be handled in this article:

1. Treaty provisions and/or domestic rules to prevent the granting of treaty benefits in inappropriate circumstances.
2. Clarification that tax treaties are not intended to be used to generate double non-taxation.

Tax policy considerations that, in general, countries should consider before deciding to enter into a tax treaty with another country.

Under the first section of the recommendations two types of cases have been identified, with each of them being split up in two case scenarios:

1. Cases where a person tries to circumvent limitations provided by the treaty itself
   1. Treaty shopping
   2. Other situations where a person seeks to circumvent treaty limitations
2. Cases where a person tries to circumvent the provisions of domestic tax law using treaty benefits
   1. Application of tax treaties to abuse the provisions of domestic tax law using treaty benefits
   2. Departure or exit taxes

Cases where a person tries to circumvent limitations provided by the treaty itself: Treaty shopping

To obtain benefits under a tax treaty it is required that a person is a resident of a contracting state. Arrangements exist under which a non-resident person of a contracting state may attempt to obtain benefits that a tax treaty provides to a resident of that state. This is called treaty shopping. These cases are typically such that a resident of a third state attempts to indirectly gain the benefits of a tax treaty between two contracting states.

Treaty shopping had already been addressed in 1977 in the Model Tax Convention by introducing the concept of beneficial owner. This dealt with simple treaty shopping situations where income is paid to an intermediary resident of a treaty country who is not treated as the owner of that income for tax purposes. These situations apply to for example agents or nominees. These parties act on behalf of another entity, but in the meantime make use of the treaty provisions of the state where they reside.

In the years following, various reports have been published that further expanded the concept of beneficial owner. The use of conduit companies for treaty shopping has also been included in these updates.

• 1986: Double Taxation and the Use of Base companies
• 1986: Double Taxation and the Use of Conduit Companies
• 1992: Various examples of provisions dealing with different aspects of treaty shopping were added to the Model Tax Convention
• 2003: Restricting the Entitlement to Treaty Benefits
• 2014: Model Tax Convention updated for clarification of beneficial ownership once more

Despite all the work done over time on treaty shopping the OECD has recognized that these concepts alone were not sufficient to prevent treaty shopping. Countries therefor have used different approaches to address treaty shopping cases that were not covered in the Model Tax Convention or any of the other OECD reports on the subject.

In BEPS Action 6 an approach is recommended to address treaty shopping situations-

• First, a clear statement that the Contracting States, when entering into a treaty, wish to prevent tax avoidance and, in particular, intend to avoid creating opportunities for treaty shopping will be included in tax treaties.
• Second, a specific anti-abuse rule based on the limitation-on-benefits provisions included in treaties concluded by the United States and a few other countries will be included in the OECD Model. Such a specific rule will address a large number of treaty shopping situations based on the legal nature, ownership in, and general activities of, residents of a Contracting State.
• Third, in order to address other forms of treaty abuse, including treaty shopping situations that would not be covered by the LOB rule described in the preceding bullet point (such as certain conduit financing arrangements), a more general anti-abuse rule based on the principal purposes of transactions or arrangements (the principal purposes test or PPT rule) will be included in the OECD Model. That rule will incorporate the principles in which the benefits of a tax treaty should not be available where one of the principal purposes of arrangements or transactions is to secure a benefit under a tax treaty and obtaining that benefit in these circumstances would be contrary to the object and purpose of the relevant provisions of the tax treaty.

The provisions of a limitation-on-benefits rule (LOB rule) are based on objective criteria. These provide more certainty than the PPT rule, which requires a subjective case-by-case analysis, on what can reasonably be considered to be one of the principal purposes of transactions or arrangements.

It is advised that countries implement at least the statement in their treaties. The LOB rule and the PPT rule can be implemented where appropriate and not already covered by domestic law. It is not the intention of BEPS Action 6 that already existing treaties be renegotiated if the current treaty is sufficient to both contracting states in addressing treaty shopping. However, when renegotiating these recommendation should be reviewed.

Further, the LOB rule will be included in the OECD Model and has become a part of the BEPS Action 15 work on Multilateral Instruments to be included as a minimum standard. Countries can elect to implement the multilateral instrument and as part of that update their treaties to at least include the minimum standard.

Cases where a person tries to circumvent limitations provided by the treaty itself: Other situations where a person seeks to circumvent treaty limitations

Besides being a resident of a contracting state a person should satisfy other conditions in order to obtain the benefits of tax treaties. In certain cases it may be possible to enter into transactions for the purposes of satisfying these conditions and as such benefit from the tax treaty. This is considered inappropriate use of tax treaties.

For these situations targeted specific anti-abuse rules are recommended as they generally provide greater certainty for taxpayers and tax administrations. Some of those rules are already found in the Model Tax Convention. Action 6 provides examples of situations where specific anti-abuse rules may be helpful and proposals for addressing these situations.

• Splitting-up of contracts: Splitting up contracts for less than twelve months and setting each contract with a different company although all belong to the same group. This is specifically addressed with the principal purposes test (PPT) rule.
• Hiring-out of labour cases: The attempt to obtain exemption from source taxation by hiring out labour. This is the hiring of foreign employees who perform work that forms an integral part of the company. For example a shipyard that hires foreign employees to do the painting work on the ships in their own docks. Domestic laws and/or treaties may provide for reduced taxation or exemption for these cases. It has been concluded there are enough provisions available that adequately deal with this kind of abuse.
• Transactions intended to avoid dividend characterization: The entering into transactions to characterize an item of income not as a dividend but as for example a capital gain. Such a characterization would lower or prevent taxation in certain treaties. There has been discussions to amend the definition of dividends and interest in the treaties. This would permit the application of domestic law rules that characterize an item of income as dividend or interest. This is outstanding and will be examined after the BEPS Action Plan is completed.
• Dividend transfer transactions: Treaties may provide for lower dividend tax rates. To prevent abuse of this rule by setting up an arrangement to obtain a shareholding subsequently followed by a dividend distribution with the purpose of lowering taxes paid it is advised to add a minimum percentage holding of 25% for a minimum period of 1 full year to the treaty provisions. Also more subjective provisions could be added to the treaty that look at the purpose of the arrangement/transaction to deny the granting of lower taxation if that purpose is to be found to be purely setup for obtaining the granting of lower taxation. Also intermediary entities that are setup with the purpose of abusing the treaty should be included in these kind of provisions according to the recommendations.
• Transactions that circumvent the application of capital gains taxes: A contracting state may tax realized capital gains on shares of companies that derive more than 50% of their value from immovable property in the contracting state. This means that when transacting the shares (that in turn own the immovable property) capital gains may be realized by the seller of the shares. In case more than 50% of the value of those shares is sourced from the immovable property, then the state in which the immovable property is situated may tax these realized capital gains. Recommendations are made to not only include taxation on capital gains but also include gains from the alienation of interests in other entities. Further recommendations are, as with the dividend transfer transactions described above, to insert a holding period of 1 full year to address property contributions shortly before sales of shares.
• Tie-breaker rule for determining the treaty residence of dual-resident persons other than individuals: Dual resident companies are to be considered a residence in only one of the contracting states under a tax treaty. The rule to base this determination on was based on the effective place of management. This has been changed in the Model Tax Convention in 2014. These situations are now handled on a case-by-case basis and by mutual agreement of the contracting states. Contracting states are however flexible to use the effective place of management rule, that was previously in place in their treaty.
• Anti-abuse rule for permanent establishments situated in third states: Transferring shares, debt-claims, rights or property to permanent establishments in preferential tax regimes in third states may lead to situations where income from the permanent establishment is not or very low taxed in any of the states. This can happen when a company derives income from a permanent establishment in a third state, which is tax exempt and at the same time can claim treaty benefits to that income which effects in tax exemption. To prevent these setups it is advised to include in the treaties that a company cannot claim treaty benefits in the source state on income derived from a permanent establishment situated in a third state if taxes imposed in the third state are less than 60% of the taxes that would be imposed had the income been earned in the source state. This however does not apply to income derived from the other state if it concerns income derived from a permanent establishment incidental to the active conduct of a business or the income derived from the other state is royalties that are received as compensation for the use of, or the right to use, intangible property produced or developed by the enterprise through the permanent establishment.

Cases where a person tries to circumvent the provisions of domestic tax law using treaty benefits

Tax treaties can facilitate tax avoidance on domestic law level. In such cases a treaty benefit is used to lower the taxable base on a domestic level. Identified strategies are for example:

• Thin capitalization and other financing transactions that use tax deductions to lower borrowing costs;
• Dual residence strategies (e.g. a company is resident for domestic tax purposes but non-resident for treaty purposes);
• Transfer mispricing;
• Arbitrage transactions that take advantage of mismatches found in the domestic law of one State and that are
  • related to the characterization of income (e.g. by transforming business profits into capital gain) or payments (e.g. by transforming dividends into interest);
  • related to the treatment of taxpayers (e.g. by transferring income to tax-exempt entities or entities that have accumulated tax losses; by transferring income from non-residents to residents);
  • related to timing differences (e.g. by delaying taxation or advancing deductions).
• Arbitrage transactions that take advantage of mismatches between the domestic laws of two States and that are
  • related to the characterization of income;
  • related to the characterization of entities;
  • related to timing differences.
• Transactions that abuse relief of double taxation mechanisms (by producing income that is not taxable in the State of source but must be exempted by the State of residence or by abusing foreign tax credit mechanisms).

Action 2 (Hybrid Mismatch Arranges), Action 3 (CFC Rules), Action 4 (Interest Deductions) and Actions 8-10 (Transfer Pricing) have addressed many of these transactions. This Action 6 aims at ensuring that treaties should not prevent the application of specific domestic law that has the aim of preventing such strategies as outlined above. In other words there should not be situations where domestic law is ruled out by a tax treaty. Granting benefits of treaties in these situations is considered to be inappropriate as the result would an avoidance of domestic tax.

A new general anti-abuse rule will incorporate the principle that the benefits of a double taxation convention (tax treaty) 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. This rule will be included in the OECD Model Tax Convention.

Inserting this principle into tax treaties by contracting states will make very clear that the will deny any transactions or arrangements that are deemed to be inappropriate.

Application of tax treaties to restrict a Contracting State’s right to tax its own residents

In those situations where a tax treaty limits the right of a state to tax its own residents where this is not intended there should be a specific provision added to the treaty clearly listing the exceptions.

Departure or exit taxes

In a number of States, liability to tax on some types of income that have accrued for the benefit of a resident (whether an individual or a legal person) is triggered in the event that the resident ceases to be a resident of that State. Taxes levied in these circumstances are generally referred to as departure taxes or exit taxes and may apply, for example, to accrued pension rights and accrued capital gains.

Double taxation can occur in cases where a person is a resident of two states at different times and there is a different tax timing on the income by these two states.

The approach that is recommended for these situations would be for the two states to agree that each state should provide relief for the residence-based tax that had been levied by the other state. This would mean that the new state of the person would provide relief for the exit taxes of the previous state.

Tax treaties were originally created to prevent double taxation. Over time it has occurred that by using the benefits of these treaties situations could arise of double non-taxation. This has been addressed by BEPS Action 6 with replacing the title recommended by the OECD Model Tax Convention. The proposed title of a tax treaty now reads:

Convention between State A and State B for the elimination of double taxation with respect to taxes on income and on capital and the prevention of tax evasion and avoidance.

Having this clear statement in a tax treaty allows states to deny any granting of benefits if they deem the transactions or arrangements to be for the purpose of tax evasion and/or avoidance.

Any country has its own sovereign right to decide if it wants to enter into tax treaties with any other state. The tax policy considerations that should be taking into account with this decision are to evaluate the extent to which the risk of double taxation actually exists in cross-border situations involving their residents. Many double taxation issues can be solved with application of domestic law provisions and do not require tax treaties as such.

Another consideration is the effect that a tax treaty may have on cross-border trade and investment. A tax treaty may encourage and foster economic ties between countries due to the greater tax certainty for taxpayers. This may or may not be a decisive factor for countries to enter into tax treaties with each other.