BEPS Action 6: Preventing Treaty Abuse

I.                Background

The OECD Base Erosion and Profit Shifting (BEPS) Action Plan identified diverse issues regarding the manner in which multinational enterprises (MNEs) conduct their business in cross-border transactions. Among the issues that the BEPS project identifies we can find treaty abuse. Particularly,  BEPS project, in its Action 6, addresses to treaty shopping as one of the most important sources for BEPS concerns.

MNEs and other taxpayers that engage in treaty shopping and other treaty abuse strategies undermine countries’ tax sovereignty by claiming treaty benefits in certain circumstances under which these benefits were not intended to be granted. This leads to deprive contracting stets from tax revenues.

In other words, treaty shopping aims to obtain treaty benefits so that the applicant can obtain a reduction of withholding tax (WHT) in the source state through the application of the provisions of the tax treaty without being entitled to them. Generally, this practice could be achieved through the interposition of conduit vehicles such as legal entities like companies, partnerships or trusts, depending on the jurisdictions. These entities need to be resident in certain state which has concluded a specific tax treaty that becomes beneficial to another taxpayer resident in the state in which the income is obtained. Thus, treaty shopping is no other thing than the use of tax treaties by persons who are not themselves within the personal scope of the treaty itself.

In this regards, under the Action 6, the OECD released a report in September 2014 which contained two approaches to counter the effects of treaty shopping. One of the approaches was based on the principal purpose test (PPT), which would aim to deny treaty benefits if there was a view by the tax administration of a contracting state that the principal purpose of the transaction was obtaining the benefits of the treaty.

The second approach was the inclusion of a limitation of benefits (LOB) clause, following the one already applied by the Unites States (U.S.) its tax treaties, where only certain defined resident taxpayers are eligible to get the relief from the treaties.

In November 2014 with a set of recommendations to address this issue through changes in the OECD Model Treaty Convention (MTC) and the MTC Commentary. This deliverable was issued as a discussion draft and titled “Follow up work on BEPS Action 6: Preventing Treaty Abuse (Discussion Draft).

The above Discussion Draft (DD) included the works of the Working Group on the potential changes to the MTC and the Commentary.

On January 22nd, 2015, a public consultation was held. The relevant stakeholders provided with their comments and on March 2015, a follow up meeting was held.

On May 21st, 2015, the Working Group undertook further consideration on the comments received through the public consultation and the follow up meeting. Additional comments were received by the Working Group in June 2015.

The Working Group issued the Final Report on October 5th, 2015, reflecting the conclusions to which the Working Group arrived, together with some recommendations on how to include changes to the MTC provisions and the Commentary.

The Final Report was titled: “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances”. These circumstances were identified as: (i) Cases where a person tries to circumvent limitations provided by the treaty itself; and (ii) Cases where a person tries to abuse the provisions of domestic tax laws using treaty benefits.

The Final Report is divided into three sections:

1)    Section Aà Which includes anti-abuse provisions to provide safeguards versus the abuse of treaty provisions. The report notices that countries have reached agreement in setting a minimum standard of protection against treaty shopping, so it includes additional targeted rules to be included in the tax treaties addressing other forms of treaty abuse such as (i) dual resident taxpayer situations and (ii) Permanent Establishments (PEs) situated in a third state situations.

2)    Section Bà Contains provisions for a revised title and preamble of the MTC in order to clarify that the intention of the countries and the treaty itself is to prevent double taxation but without creating opportunities for tax planning aiming double   non-taxation through tax evasion or avoidance, including treaty shopping arrangements.

3)    Section C àIdentifies some tax policy considerations which should be relevant for the decision of countries to enter into a double taxation agreement with another country.

Finally, the Final Report stresses the fact that further work needs to be done under Action 6 in order to ensure effectiveness of the recommendations regarding MTC provisions and Commentary changes. The areas that require further work have been identified in the Final Report and are the following:

-        1) U.S. style LOB clauses to prevent treaty shopping, which are expected to conclude during the first half of 2016; and

    2) Treaty entitlement of benefits of non-collective investment vehicles (non-CIVs) and pension funds. The works on this topics are also aimed to be concluded during the first part of 2016.

II.                Action 6 objectives.

      The Final Report notes that there has been reached agreement among countries regarding the minimum level of protection against this practice of treaty abuse (the minimum standard). This agreement has led to have commitment within the countries to include a clear and express statement in the treaty’s wording that the common intention of the countries to enter into these type of treaties is to prevent double taxation and to promote international cross border commerce and not to create opportunities for non-taxation or reduced taxation. Hence, they would be openly rejecting the use of the treaties for tax evasion and avoidance through treaty shopping and other arrangements alike.

III.              OECD’s proposal.

Taking the above into account, the Final Report insists in drafting a clear statement to be included in the MTC that the contracting states are only entering into the tax treaty in order to prevent double taxation and to avoid creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements will be included in tax treaties.  

Furthermore, the Final Report notes the need to implement specific anti-abuse rules through an LOB clause that limits the availability of treaty benefits only to certain entities that meet certain criteria. This LOB clause will be included in the MTC. In addition, the Final Report makes clear the need to release guidelines on how to identify these conditions, insisting on targeting the legal nature of the entity requesting the treaty benefits, its ownership structure, and general activities of the entity. This will help contracting states to ensure that there is a sufficient and strong link between the entity requesting the treaty benefits and the residence state.

Regarding other forms of treaty abuse including treaty shopping situations that would not be covered by the above described LOB rule, the Final Report notes the need of a general anti-abuse rule based on the principal purpose of transactions or arrangements, thus, insists on the use of the PPT rule. The PPT rule will be included in the MTC and will aim to deny treaty benefits in those cases where one of the principal purposes of transactions or arrangements is to obtain treaty benefits. There would only be possible to obtain treaty benefits if it is established that granting these benefits would be in accordance with the object and purpose of the provisions of the treaty.

IV.            Personal view.

In my experience as tax adviser, the inclusion of LOB clauses has proven to be the most effective measure to prevent treaty abuse, since it makes very hard to prove that the entity requesting the benefit of the treaty has a strong link with its country of residence if it is letterbox or shelf entity. This is because the LOB clause requires, among others, that the entity’s ownership (at least 50%) has to be in the hands of residents in the same country.

On the other hand, the recommendation of a clear statement in the preamble of the MTC that the intention of the treaty is not to make room for tax planning opportunities aiming treaty shopping seems a bit naive and hardly effective.