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OECD proposes changes to model tax convention to address treaty abuses

March 25, 2014

The Organization for Economic Cooperation and Development (OECD) has released a discussion draft following up on its action plan, published over the summer, to address base erosion and profit-shifting (BEPS) issues. The discussion draft specifically addresses the issue of treaty abuse and proposes a number of changes to its Model Tax Convention.

Background. The OECD is an international organization that “provides a forum in which governments can work together to share experiences and seek solutions to common problems.” It currently has 34 member countries, including the U.S. According to the OECD’s website, BEPS “refers to tax planning strategies that exploit loopholes in tax rules to make profits disappear for tax purposes or to shift profits to locations where there is little or no real activity but where they are lightly taxed, resulting in little or no overall corporate tax being paid.” In most cases, BEPS strategies are legal.

A report issued by the OECD last February asserted that current international tax standards have not kept pace with changes in global business practices. This potentially allows sophisticated multinationals to achieve single digit effective tax rates while their smaller counterparts, who often only operate domestically, pay tax at effective rates of up to 30%.

The OECD “is looking at whether, and if so why, the current rules allow for the allocation of taxable profits to locations different from those where the actual business activity takes place.” Its report suggested that the OECD and G-20 countries take a coordinated approach to developing an action plan that could successfully deter base erosion and profit shifting behaviors by multinationals. (See Weekly Alert ¶  14  04/25/2013 for more details on the report and for a Treasury official’s discussion of the U.S.’s position on BEPS.)

Back in July, the OECD issued its action plan, which lists 15 specific actions to address BEPS. Among other things, it called for new international standards on corporate taxation, a better alignment of taxation with income-producing activities, improvements to the current transfer pricing rules, and greater overall transparency. (See Weekly Alert ¶  7  07/25/2013 for more details.)

Action 6 of the BEPS action plan called on the OECD to work to: (i) develop model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances, (ii) clarify that tax treaties are not intended to be used to generate double non-taxation, and (iii) identify the tax policy considerations that, in general, countries should consider before deciding to enter into a tax treaty with another country. Each of these areas of work, and OECD’s recommendations, are addressed below.

Prevent inappropriate granting of treaty benefits. The OECD stated that, in order to determine the best way of preventing the granting of treaty benefits in inappropriate circumstances, it distinguished between cases where a person tries to circumvent limitations provided by the treaty itself, as opposed to where a person tries to use treaty benefits to circumvent domestic law provisions. The discussion draft notes that the abuse in first situation would be most directly addressed by the inclusion of anti-abuse rules in treaties themselves, whereas the second abuse would require changes to both treaty provisions and domestic anti-abuse rules.

… Attempts to avoid treaty limitations. In general, a person who seeks to obtain benefits under a tax treaty must be a resident of a “Contracting State.” However, there are a number of arrangements where a person who is not a resident of a Contracting State may attempt to obtain benefits that a tax treaty grants to residents (“treaty shopping”). Examining various treaty practices, the OECD recommended using the following three-pronged approach to address treaty shopping situations:

 

1. Include in the title and preamble of tax treaties 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.
2. Include in tax treaties a specific anti-abuse rule based on the limitation-on-benefits (LOB) provisions (see below) included in several existing treaties. This approach would address a large number of treaty shopping situations based on the legal nature, ownership in, and general activities of, residents of a Contracting State.
3. Add to tax treaties a more general anti-abuse rule (also called a GAAR; see below) designed to cover other forms of treaty abuse not covered by (2), above, that would incorporate principles under which the benefits of a tax treaty would not be available where one of the main purposes of arrangements or transactions is to secure a benefit under a tax treaty and obtaining that benefit would be contrary to the object and purpose of the relevant provisions of the tax treaty.

 

The discussion draft included a proposed article to be added to the existing text of the Model Tax Convention (MTC) titled “Entitlement to Benefits” that is based on similar LOB provisions in tax treaties concluded by the U.S., as well as in some treaties concluded by Japan and India. This article would provide detailed rules on how to determine whether a person is entitled to treaty benefits.

RIA observation: The LOB provisions present in many tax treaties between the U.S. and other countries generally prevent residents of third States from obtaining treaty benefits through the use of legal entities established in a State with a principal purpose of obtaining the benefits of a tax treaty between the States. For instance, under the U.S.-Belgium tax treaty, the LOB provisions apply a series of mechanical tests under which it is assumed that a taxpayer that satisfies the requirements of any of the tests probably has a real business purpose for the structure it has adopted or has a sufficiently strong nexus to the other State (e.g., a resident individual) to warrant benefits.

The OECD suggested adding the following language to the MTC for the GAAR: “Notwithstanding the other provisions of this Convention, a benefit under this Convention shall not be granted in respect of an item of income if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the main 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.” Examples of situations in which this provision would or would not apply were also provided.

The OECD would also change the MTC’s rules for determining how to treat a person (other than an individual) that is a resident of both Contracting States to a treaty, as well as add an anti-abuse provision specifically dealing with “triangular” cases involving income attributable to a permanent establishment in a third State subject to low taxation.

… Attempts to avoid domestic law provisions. According to the discussion draft, “[m]any tax avoidance risks that threaten the tax base are not caused by tax treaties but may be facilitated by treaties.” Examples of such avoidance strategies include thin capitalization and other financing transactions that use tax deductions to lower borrowing costs, as well as dual residence strategies (e.g., where a company is resident for domestic purposes but non-resident for treaty purposes). As noted above, these situations will require both addressing the treaty issues as well as changing domestic law. The OECD also stated that many of the abusive transactions that fall within this category (i.e., situations involving attempts to use treaty provisions to avoid domestic law) will be addressed through work on other aspects of the Action Plan—in particular, Actions 2 (on hybrid mismatch arrangements), 3 (on strengthening the CFC rules), 4 (on limiting base erosion via interest deductions and other financial payments), and 8 through 10 (on transfer pricing).

The OECD also proposed adding a number of provisions to the MTC that confirmed the “general principle that the Convention does not restrict a Contracting State’s right to tax its own residents,” but listed the exceptions where the Convention contemplates that a Contracting State may have to provide treaty benefits to its own residents.

“Double non-taxation.” Action 6 also called on the OECD to “clarify that tax treaties are not intended to be used to generate double non-taxation.” The discussion draft notes that while existing treaties were developed with the prime objective of preventing double taxation, the aim of preventing tax avoidance has been added over time. In order to provide the clarification required by Action 6, the discussion draft would change the title of the MTC to include the language “prevention of tax evasion and avoidance” in addition to “elimination of double taxation,” and would change the preamble to expressly state the intent to “eliminate double taxation… without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance.”

The OECD would also add to the MTC language on the exchange of information and administrative cooperation among OECD member countries for the purpose of preventing tax evasion and avoidance. It noted that the title and preamble constitute a general statement of the objective and purpose of the MTC, and that this language should “play an important rule in the interpretation” of the its provisions.

Tax policy considerations. The final mandate in Action 6 was to identify tax policy considerations that countries generally should consider before entering into a tax treaty with another country. The OECD would add to the MTC a series of new paragraphs setting out the following considerations as relevant to determining not only whether to enter a treaty, but also whether to modify, replace, or even terminate an existing treaty:

 

…the existence of risks of double taxation resulting from the interaction of the tax systems of the two States involved;
…the extent of existing or projected cross-border trade and investment between the two States;
…whether, when contemplating a treaty with a State that levies no or low income taxes, there are risks of double taxation that, by themselves, would justify a tax treaty;
…whether there are elements of another State’s tax system that could increase the risk of non-taxation;
…the extent to which domestic provisions (e.g., exemptions or credits) could eliminate juridical double taxation;
…the various features of tax treaties that encourage and foster economic ties between countries, the greater certainty of tax treatment for taxpayers who are entitled to benefit from the treaty, and the fact that tax treaties provide a mechanism for the resolution of cross-border tax disputes; and
…the extent to which a potential treaty partner is willing and able to effectively implement administrative assistance provisions, such as the ability to exchange tax information.
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