Huw Witty Partner, Head of Tax
A multilateral convention to combat tax avoidance must be good news, mustn’t it? Huw Witty considers its advantages and disadvantages.
On 7 June 2017, 68 countries signed a multilateral convention (tinyurl.com/BEPStreaty) as part of the campaign by the Organisation for Economic Cooperation and Development (OECD) against tax avoidance, also referred to as the BEPS project. Two more countries have signed up to the convention since, although notable absences include Brazil and the US. The convention is a complicated document, both in terms of its contents and implementation, because it seeks to impose minimum standards in all the double tax treaties of all its signatories. It is perhaps best understood in the context of the BEPS project.
What is BEPS?
BEPS stands for ‘base erosion and profit shifting’. It is a name for a process being undertaken by the OECD to prevent international enterprises reducing their worldwide aggregate exposure to taxation. Two ways organisations do this is by exploiting variations in the tax rules of different regimes or by establishing profit centres with few staff in low tax jurisdictions. During the BEPS project, the OECD highlighted several areas that it considered to be abusive. The key target appears to be USbased global enterprises, although a case could be made that the only tax these companies are saving is US tax.
The OECD proposed action to limit perceived tax avoidance in these areas. These included limiting interest deductibility, requiring disclosure of aggressive tax planning, preventing avoidance of permanent establishment status and introducing a multilateral instrument.
The convention is the document referred to as the multilateral instrument in the BEPS action points (tinyurl.com/BEPSact). It provides a template of provisions to replace current provisions of double tax treaties that countries have entered into without the need for each arrangement to be negotiated separately. It is estimated that the convention will affect more than 2,000 double tax treaties so the negotiation of bilateral changes to these would have taken a long time.
Also, if negotiated bilaterally, some treaties may have been changed in advance of others. Hence, taxpayers may have sought to relocate from a jurisdiction that had implemented the BEPS changes to one that had yet to do so to preserve the tax benefits considered to be abusive. The convention should come into effect simultaneously and this is expected to be on 1 January 2019.
Because the convention is, in effect, a template for change to a vast number of tax treaties, it must be flexible and take account of their different nature. A signatory to the convention can specify which of its double tax treaties will be covered by the multilateral convention. Further, some provisions are optional and will apply only if each tax treaty party opts for the particular provision. Other provisions enable one party to the treaty to choose one option and another to choose another.
The provisions of the multilateral convention reduce potential abuse by imposing ‘minimum standards’ in key areas:
- hybrid mismatches;
- treaty shopping;
- preventing artificial avoidance of a permanent
- establishment; and
- providing effective disputes management mechanisms under a double tax treaty.
It is understood that the US did not sign the multilateral convention because it considers that its double tax treaties already meet these minimum standards
These are discrepancies arising from a difference in the tax treatment of a transaction or an entity under the laws of two separate jurisdictions.
Examples include entities that are treated as partnerships in one jurisdiction and corporates in another or financial transactions that are treated as debt in one country (so that a payment in respect of it may be tax deductible interest) and equity in another (so that the counter-party receives a dividend that may not be taxable or may carry a tax credit).
This involves establishing a presence in a jurisdiction to exploit a double tax treaty entered into by that country rather than for commercial purposes. For example, a parent company in Israel may wish to establish a subsidiary in France. If it did so directly it may suffer withholding tax on dividends paid to it. However, if it set up a UK subsidiary that in turn established the French subsidiary it may be entitled to receive dividends without withholding tax.
The convention contains provisions to prevent such abuses. There is a statement of intention that the purpose of the treaty is to prevent double taxation, not to reduce or avoid taxation altogether. However, from the comments of the First-tier Tribunal in P Weiser (TC2178) this would appear to be a principle of English law in any event.
There is also to be a principal purpose test which includes a general anti-abuse rule based on the principal purpose of the transaction or arrangement or a limitation of benefits rule. The latter rule will deny some treaty benefits to taxpayers that do not qualify under specific categories of exemption. At its simplest, the limitation of benefit rule states that a person generally resident in a tax jurisdiction can qualify for relief, but entities that are a mere foil for a resident in the third jurisdiction may not.
Avoiding a permanent establishment
The BEPS project also seeks to prevent companies artificially arranging their affairs so that they do not fall within the meaning of a permanent establishment in a jurisdiction for the purposes of a relevant double tax treaty. This is aimed at commissionaire arrangements – avoidance by using specific exemptions in a double tax treaty or fragmentation schemes. The latter is a scheme in which activities – which if carried out in one company would constitute a permanent establishment – are spread among related companies with the intention that, seen separately, none of them would constitute a permanent establishment.
Effective dispute resolution
All double tax treaties contain a provision under which any disputes on the application of specific aspects of the treaty may be resolved. In practice, it is understood that the provisions have been rarely used and the process has been perceived as a black hole into which a matter could disappear without resolution for a long period.
The intention is that the new rules will allow the dispute to be resolved within a comparatively short time.
What has the UK done?
The first point to note is that the UK has not sought to apply the multilateral convention to its treaties with Jersey, Guernsey and the Isle of Man, despite them having signed it. This may be because the UK has recently amended its treaties with these dependencies and considers that they therefore meet the minimum BEPS standards.
The first provision the UK has opted to apply relates to transparent entities in connection with the hybrid mismatch rules. The provision opted by the UK is similar to wording included in some of the UK’s double tax treaties (for example, Article 1(8) of the US/UK double tax treaty. The combination of the application of this provision to the UK’s double tax treaties and the UK’s domestic anti-avoidance rules relating to hybrid mismatches introduced in FA 2016 (see TIOPA 2010, Pt 6A) will result in the UK having at least satisfied the minimum standard required by BEPS.
On treaty abuse, the UK has chosen to adopt the preamble that the treaties are to avoid double taxation rather than assist in the payment of no or reduced taxation, although this may not have been necessary.
Further, the UK will adopt the general anti-avoidance rule in the form of the principal purpose test. This test is perhaps to be preferred to the more formulaic limitations of benefits test. The latter could take away treaty benefits from commercial structures such as investment funds, the investors in more than half of which would not qualify for relief under the relevant double tax treaty.
However, application of the principal purpose test will be important. If the provision were to be applied over-zealously, it could be used to deny treaty benefits to genuine group finance companies. For example, it is considered that treaty relief should not be denied simply because an international group finance company is established in a country that has an appropriate tax regime and a wide treaty network.
The UK has also opted to introduce a rule preventing the avoidance of a permanent establishment through fragmentation.
Matter of interpretation
Finally, the UK has adopted a mutual agreement procedure under which a taxpayer may apply to resolve a question on the interpretation of a double tax treaty. At first sight, this appears to be good news and it may expedite the resolution of disputes. However, the downside is that there is no appeal. Hence, if a dispute under a treaty concerns the country to which tax is payable rather than the amount, double tax treaty disputes resolution provisions may seem sensible. In cases when the tax liability is in point, however, the taxpayer may seek a ruling under a treaty that does provide a right of appeal.