November 2014
Practice Group:
Action 6 – Preventing the Granting of Treaty
Benefits in Inappropriate Circumstances
By Philip Diviny
Tax
Action 6 of the BEPS Action Plan identified treaty abuse as one of the most important
sources of BEPS concern. The report offers alternative model provisions for the prevention
of treaty abuse given constitutional and other restrictions that may apply to some treaty
countries. Notwithstanding, each alternative shares a common goal, being to ensure that
states incorporate in their treaties sufficient safeguards to prevent treaty abuse.
Further work is required in respect of the model provisions, and, to this end, the proposed
wording should be considered as a draft, prior to the release of the final version in
September 2015. The recommendations in respect of Action 6 are subject to the findings on
other BEPS deliverables in respect of action items where reports have not yet been
released.
The key proposals from the report are to amend the OECD Model Tax Convention
(Convention) in the following ways:
1. Develop model treaty provisions and recommendations regarding the
design of domestic rules to prevent the granting of treaty benefits in
inappropriate circumstances
The report notes that inappropriate treaty benefits can arise in different circumstances,
including:
• cases where a person tries to circumvent limitations provided by the treaty itself; and
• cases where a person tries to circumvent the provisions of domestic tax law using treaty
benefits.
The report focuses on the first of these sources by including anti-abuse rules in the model
treaty. The second situation involves the avoidance of domestic laws, which cannot be
addressed exclusively through treaty provisions but require domestic anti-avoidance
provisions. The need for these domestic laws can, however, give rise to conflicts between
those domestic rules and the treaty provisions, either in their current or proposed form.
The report recommends a three-pronged approach to address treaty shopping
arrangements:
1. that treaties include an express statement that the contracting states intend to avoid
creating opportunities for double non-taxation or reduced taxation through tax evasion or
avoidance, including treaty shopping arrangements;
2. to include in treaties a specific anti-abuse rule (Limitation of Benefits (LOB) clause)
requiring substantive ownership of the entity claiming the benefits of the Convention to be
Action 6 – Preventing the Granting of Treaty Benefits in Inappropriate
Circumstances
held within the jurisdiction or requiring the entity to conduct active business activities
within that jurisdiction; and
3. introducing a general anti-abuse rule (Principal Purposes Test (PPT)) to cover other
forms of treaty abuse.
Limitation of Benefits
The proposed LOB article provides that residents of a contracting state are not entitled to the
benefits of the treaty unless:
• they are “qualified persons” for the purposes of the treaty (subject to some minor
exceptions);
• the item of income is derived in connection with the active conduct of a trade or business
in the person’s state of residence;
• it is an entity owned by residents of a contracting state, provided the residents would have
been entitled to equivalent benefits if they had invested directly; or
• they are subject to specific exemption by the competent authority of a contracting state.
Qualified Persons
The proposal contains specific rules outlining when different entities will be considered
qualified persons. Qualified persons will include:
• individuals who are resident in a contracting state;
• contracting states themselves and entities wholly owned by a contracting state;
• publicly traded companies and entities resident in a contracting state if:
o throughout the taxable period, the principal class of its shares is regularly traded on
one or more recognized exchanges, and
• those exchanges are located in the contracting state of which the entity is
resident; or
• the company or entity’s primary place of management and control is in the
contracting state of which it is resident; or
o at least 50 percent of the aggregate voting power and value of the shares in the entity
is owned directly or indirectly by five or fewer publicly traded companies. If the publicly
traded companies are indirect owners, each intermediate must be a resident of one of
the contracting states;
• specified charitable organizations without regard to their residency;
• resident pension funds if more than 50 percent of the beneficial interests in the fund are
owned by resident individuals and specified “funds of funds”; and
• non-individuals if:
o 50 percent or more of each class of shares in the entity is owned directly or indirectly
(on at least half the days in the taxable period) by residents of the contracting state of
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Action 6 – Preventing the Granting of Treaty Benefits in Inappropriate
Circumstances
which the entity is resident and who are themselves entitled to treaty benefits as
outlined above; and
o less than 50 percent of the entity’s gross income for the taxable period is paid or
accrued to persons who are not residents of either contracting state entitled to the
benefits of the treaty on the basis of being qualified persons.
The treatment of collective investment vehicles under this regime is left open with a number
of options canvassed.
It should be noted that qualified persons must still meet the other provisions of the
Convention in order to obtain specified benefits.
Active Conduct of a Business
The term business is not defined and, therefore, will take its general meaning under
applicable domestic law.
The commentary specifically notes that the business of making or managing investments for
a resident’s own account is a business for these purposes, only where the relevant activities
are part of banking, insurance, or securities activities conducted by a bank or financial
institution, insurance enterprise, or registered securities dealer. Such investment activities
carried on by other entities will not be considered the active conduct of a business. To this
end, a headquarters company solely managing investments will not be considered engaged
in the active conduct of a business.
Derivative Benefits
The derivative benefits test entitles a company that is a resident of a contracting state to
treaty benefits if the owner of the company would have been entitled to the same benefits
had the income flowed directly to that owner.
Discretionary Relief
Where a resident of one contracting state is not entitled to the benefits of the treaty because
they are not within the definition of qualifying person, discretion is afforded to the competent
authority to grant the benefits of the treaty regardless. Before exercising the discretion, the
competent authority must consider the relevant facts and circumstances and consult with the
competent authority of the other contracting state.
The request for determination can be made before or after the relevant event.
It should be noted that the LOB proposal follows U.S. practice; however, this approach may
be considered inappropriately restrictive. While the discretionary element may on one hand
be seen to overcome this, it may in reality lead to less certainty as to the application of the
LOB provisions.
Principal Purposes Test
The benefits of a treaty should not be made available where one of the principal purposes of
the transaction or arrangement is to secure a benefit under a treaty and obtaining that benefit
would be contrary to the object and purpose of the relevant provisions of the treaty.
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Action 6 – Preventing the Granting of Treaty Benefits in Inappropriate
Circumstances
The PPT supplements the LOB. A taxpayer entitled to the benefit of a treaty on the basis
that they are considered a qualified person and satisfy the LOB test may be denied those
benefits upon application of the PPT.
The PPT requires consideration of all relevant facts and circumstances to determine whether
obtaining the benefit of the treaty 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 would be in accordance with the object and purpose of the treaty. The
test requires an objective analysis of the aims and objects of all persons involved in putting
the arrangement or transaction together.
It is noted that relevant terms such as “that resulted directly or indirectly in that benefit” and
“arrangement or transaction” are deliberately broad, resulting in a widely applied test. The
term “benefit” will include all limitations of tax imposed, including tax reduction, exemption,
deferral, or refund.
The test simply requires that one of the principal purposes of the arrangement is the
obtaining of a benefit under the treaty. The test is not a sole or dominant purpose test, so
where there is more than one principal purpose (including obtaining the tax benefit), the PPT
will still apply.
As you would expect, the PPT does not contain a discretionary element and can be
distinguished from the LOB in that regard.
In reality, a treaty negotiated in the future may contain only one of the LOB or PPT, with the
adoption of both tests in the report attributed to the preferences of some jurisdictions for one
but not the other test. The adoption of both the LOB and the PPT in the one treaty would
seem to be overkill.
2. Clarification that tax treaties are not intended to be used to generate double
non-taxation
This clarification will occur through the title and preamble of the Convention to make clear
that the joint intention of the parties is to eliminate double taxation without creating
opportunities for tax evasion or avoidance, or treaty shopping. This will include referring
expressly to treaty shopping as one example of tax avoidance that should not result from tax
treaties.
3. Tax policy considerations that, in general, countries should consider
before deciding to enter into a tax treaty with another country
Having a clearer articulation of the policy considerations that countries should consider
before deciding to enter into a tax treaty could make it easier for countries to justify their
decision to enter or not to enter new treaties, as well as decisions regarding the modification
or termination of treaties previously concluded.
The main tax policy considerations include:
• double taxation and the allocation of taxing rights between the two states;
• whether there are elements of another states’ tax system that could increase the risk of
non-taxation, including tax advantages that are ring-fenced from the domestic economy;
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Action 6 – Preventing the Granting of Treaty Benefits in Inappropriate
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• the risk of excessive taxation that may result from high withholding taxes in the source
state, leading to a detrimental effect on cross-border trade and investment;
• the protection from discriminatory tax treatment of foreign investment that is offered by
the non-discrimination rules of Article 24;
• the greater certainty of tax treatment for taxpayers entitled to benefit though the mutual
agreement procedure; and
• the willingness of treaty partners to effectively implement provisions concerning
administrative assistance such as exchange of tax information and assistance in the
collection of taxes.
Author:
Philip Diviny
philip.diviny@klgates.com
+61.3.9640.4221
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