Treaty Shopping and Avoidance of Abuse

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Treaty Shopping and Avoidance of Abuse

Authors
Niels Bammens Luc De Broe As international trade and business have grown throughout the 20th century, international tax law has struggled to keep up with this evolution. Multinational enterprises have been able to exploit the lack of coordination in the international tax treaty system, often through the use of intermediaries in countries with a favourable tax system, in order to minimize their worldwide tax burden. However, it is very difficult in this regard to draw a distinction between acceptable tax planning and abuse. As a guiding principle, the OECD Commentary suggests that treaty benefits should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position (subjective component) and where obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions (objective component). [1] More specifically, treaty shopping is considered to occur where persons who are not resident in either contracting state seek to benefit from treaty advantages that would not ordinarily be available to them, [2] generally by interposing a conduit entity between the taxpayer and the source of the income, in order to benefit from the tax treaty between the source state and the conduit entitys (purported) state of residence. States have long sought to counter abusive tax practices such as treaty shopping by a myriad of techniques, ranging from the application of domestic anti-abuse doctrines to the inclusion of specific anti-abuse clauses in the tax treaty. Even though there is a consensus that such abusive practices should be prevented, it is unclear which measures are the most effective. Quite often, it seems that measures which, in theory, serve to counter abuse are ineffective or counterproductive in practice. Moreover, it is very difficult to determine whether a specific measure is efficient in countering abuse. As there is a multitude of factors at play simultaneously, it is insufficient to simply compare the states tax revenue before and after the introduction of the measure. In order to fully grasp the impact and functioning of a specific measure, a thorough analysis of all the relevant factors and empirical data is required. However, a legal analysis does not offer the necessary tools to draw meaningful conclusions from this data. Therefore, an economic perspective might prove particularly useful in this regard. In this paper, a number of issues which might benefit from an economic analysis are identified.

1. The relationship between anti-avoidance provisions and foreign direct investment

The selection of a country as a conduit state is generally based on the extent of that states tax treaty network: the more tax treaties are in force, the more opportunities for tax planning. It would be interesting to analyse these considerations from an economic point of view. More specifically, tax treaties are concluded for reasons of an economic nature: the contracting states want to stimulate reciprocal commercial relations by preventing double taxation. [3] The use of conduit companies and treaty shopping structures has very little to do with this economic objective. Treaty shopping thus upsets the balance and reciprocity of the tax treaty: in order to preserve a tax treatys inherent reciprocity, its benefits must not be extended to persons not entitled to them. [4] Therefore, the first important question concerns the effect of measures intended to prevent abuse of tax treaties on the economic objectives pursued by those treaties. The past decade has seen a significant increase in economic research studying the effect of double taxation conventions on foreign direct investment (FDI). [5] Generally, the purpose of these studies was to find empirical support for the theoretical assumption that tax treaties increase foreign direct investment. However, the empirical results offer little support for this assumption: most studies show that the effect of double taxation conventions on FDI both inbound and outbound is insignificant or even negative. [6] These results call for several important questions from a policy perspective. Our paper deals with several of these questions concerning treaty shopping and treaty abuse. The studies referred to above generally assume that tax treaties perform four primary functions, two of which are likely to increase FDI and two of which tend to reduce it. [7] First, tax treaties standardize tax definitions and jurisdictions of the treaty partners. Second, tax treaties lower withholding rates and increase tax certainty for a multinational enterprise. It can be assumed that these two functions increase FDI. A third major role played by tax treaties is to reduce tax avoidance by establishing anti-treaty shopping provisions. Finally, tax treaties serve to increase enforcement of transfer pricing regulations by introducing regulations on the calculation of internal prices, facilitating the exchange of information between tax authorities, etc. These two final functions of tax treaties tend to reduce FDI. Given the empirical evidence that tax treaties have either a small or insignificant effect on FDI, it seems that the FDI-deterrent aspects outweigh the FDI-increasing aspects. Consequently, the question arises what can be done to either promote the positive aspects, or to neutralize the negative aspects.

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Particularly, from the perspective of the present paper, the core issue concerns the anti-treaty shopping provisions: how can those provisions be adapted in order to remove their negative impact on FDI? In other words, is it possible from an economic point of view for anti-treaty shopping provisions to perform their function, while at the same time not impeding FDI? Interestingly, it seems that the negative or insignificant effect of tax treaties on FDI is only present for the level of FDI after the initial investment. In contrast, tax treaties have a positive effect on the investment decision itself. [8] In other words: companies that have a subsidiary in a certain state are not persuaded to invest more in that state when their own state of establishment concludes a tax treaty with the subsidiarys state of establishment. However, the conclusion of a tax treaty does have a positive effect on the initial investment decision: a company is more likely to establish a subsidiary in a state with which its own state of establishment has a tax treaty. Most likely, this positive effect can be explained by the certainty offered by a tax treaty: before companies decide to invest in a specific state, they want to be certain how their investment will ultimately be taxed. However, antiabuse provisions, whether laid down in a tax treaty or in domestic law, cause a certain degree of uncertainty. Therefore, it could be argued that anti-abuse provisions should cause as little uncertainty as possible in order for FDI not to be affected by them. Moreover, it seems that the uncertainty created by anti-avoidance measures creates more avoidance. [9] In particular, aggressive taxpayers will take more aggressive positions in order to cover the additional cost of the potential application of the tax-avoidance measure. Add to this the administrative costs incurred by the tax authorities and the advisory, compliance, legal, etc. costs by the taxpayer as a result of anti-avoidance measures, and one is left to wonder whether it makes sense, from an economic point of view, to implement antiavoidance measures with respect to tax treaties. Or is the overall effect of these measures ultimately positive, because risk-averse taxpayers are encouraged to stop avoiding taxes? An important aspect which is often overlooked in research-concerning measures targeting tax treaty abuse is the economic relationship between the contracting states. Particularly, when a tax treaty is concluded between two developed countries, FDI flows will generally be symmetric. However, when a tax treaty is concluded between a developed and a developing country, FDI flows may be highly asymmetric. It is difficult to filter out these effects in empirical research, but the question nevertheless remains whether it is desirable to use different antiavoidance measures depending on the nature of the economic relationship between the contracting states. It could be argued that a tax treaty between developed countries should be more concerned with promoting FDI than with preventing abuse, and that legal certainty should therefore be the top priority rather than the enforcement of anti-abuse measures. In contrast, the incentive to include stringent anti-abuse measures might be stronger in tax treaties with developing countries. [10] Is such a differentiation acceptable from an economic perspective? Moreover, how should this modulation between legal certainty and anti-abuse be designed in order to fully achieve the relevant objectives? Finally, according to some studies, the tax rates in the host state have no effect on the initial investment decision, but they do have an effect after the investment: if the effective tax rate in the host state increases, companies having a subsidiary in that state will change their behaviour in order to lower the profits reported in the host state. [11] The question thus arises whether the same effect is caused by the introduction of anti-abuse measures, such as limitation-on-benefits (LOB) clauses in tax treaties or domestic anti-abuse provisions, as these measures also cause the effective tax rate to increase. In conclusion, we are faced with a divergence between tax treaties stated purpose of promoting FDI and their apparent opposite effect. Two approaches may be suggested to remedy this divergence. As indicated earlier, the most obvious solution would be to neutralize the FDI-deterrent aspects of tax treaties, particularly by ensuring legal certainty. However, it seems difficult to reconcile this approach with the inherent uncertainty of antiavoidance measures. Therefore, it might be necessary to rethink the objective of tax treaties. Given the empirical data, it seems difficult to maintain that the objective of promoting FDI (or, more generally, to remove the obstacles caused by double taxation) is on par with the objective to reduce tax evasion by multinational enterprises. In order to ensure an appropriate modelling and interpretation of a tax treaty, it is necessary to identify its exact object and purpose. [12]

2. Domestic anti-avoidance measures and economic substance [13]

Different approaches can be taken in designing anti-treaty shopping measures. Generally, these measures are intended to deny tax benefits where transactions are carried out with tax motives being their sole or predominant purpose (e.g. the interposition of a company in another state for tax minimization purposes). These measures are often based on an economic analysis, in that they aim to weigh the tax purpose of the transactions against its economic purpose. Of particular interest here is the economic-substance doctrine, as it has developed in US case law. The general idea underlying this doctrine is that transactions should not be granted tax benefits when they lack economic substance, despite complying with the literal requirements of the statute. [14] A slightly different interpretation of this idea requires the transaction to yield a positive pre-tax profit in order to benefit from the tax advantages at

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issue. [15] Accordingly, the core issue in this doctrine is whether what was done, apart from the tax motive, was the thing which the statute intended. [16] In general, US courts have therefore held that a transaction will not be recognized for tax purposes when (1) the taxpayer has no business purpose other than obtaining tax benefits and (2) the transaction has no economic substance because there is no reasonable possibility of profit. [17] Despite its apparent simplicity, this doctrine causes a number of practical difficulties. For instance, should the assessment only be concerned with (objective) economic consequences, or also with (subjective) motive or intent? In other words, should the sole tax motivation be sufficient to deny tax benefits to a transaction that nevertheless creates objective economic consequences? Moreover, it is necessary to define concepts such as business purpose and economic substance. An economic analysis could prove useful in providing an appropriate definition. As mentioned earlier, the main objective of tax treaties is generally thought to be the promotion of reciprocal trade between the contracting states by removing obstacles caused by double taxation. On the other hand, the economic-substance doctrine is based on the idea that transactions should be denied tax benefits if they lack sufficient economic substance. Accordingly, in defining the degree of economic substance that is necessary to enjoy the tax treaty benefits, account should be taken of the economic purpose of the tax treaty. Particularly, it could be argued that, under the economic-substance doctrine, tax treaty benefits are limited to those transactions that benefit the economic relationship of the contracting states and stimulate reciprocal trade between those states. [18] However, it is difficult to determine exactly how much business must be done to meet this threshold. Moreover, as mentioned earlier, the economic purpose of tax treaties may be less pronounced than its anti-abuse purpose. The question thus arises whether this observation affects the interpretation of the economic-substance test in the tax treaty context. Case law dealing with the interpretation of the economic-substance test reveals the intricate nature of this assessment. Consider, for instance, two similar cases concerning back-to-back loans. In Aiken Industries, a US company borrowed funds from ECL, a related company established in the Bahamas. [19] The interest was paid to a related company in Honduras in order to benefit from the exemption from US withholding taxes on interest payments under the USHonduras treaty. The US Tax Court decided that the interest was not received by the Honduran company within the meaning of Art. 9 of the treaty. As the term received by was not defined in the treaty, the Tax Court interpreted it in accordance with domestic law. [20] The Court thus interpreted received by to mean interest received by a company as its own and not with the obligation to transmit it to another. The Honduran company was required to transmit the amount it received to ECL and it did not make any profit on the transaction. The Court therefore held that the transaction did not have any valid economic or business purpose. Its only purpose was to obtain the treaty benefits. As the Honduran company was merely a conduit, it could not be said to have received the interest as its own. Accordingly, the Tax Court denied the treaty benefits. The facts of Northern Indiana were quite similar. [21] The taxpayer, a US corporation, incorporated a wholly owned subsidiary (Finance) in the Netherlands Antilles. Finance was organized for the purpose of obtaining funds for the taxpayer by issuing notes in the Eurobond market and then lending the proceeds to the taxpayer. Finance thus issued USD 70 million worth of 7-year notes in the Eurobond market at an annual interest rate of 17.25%. The taxpayer unconditionally guaranteed payment of the interest and principal on the notes. On the same date, the taxpayer issued to Finance a USD 70 million note, bearing annual interest of 18.25% and Finance remitted the proceeds of the Eurobond offering to the taxpayer. The purpose of the transaction was to obtain the exemption of withholding tax on interest under the tax treaty between the United States and the Netherlands (as extended to the Netherlands Antilles). The Court of Appeals applied the economic-substance doctrine and held that transactions involving a foreign corporation are to be disregarded for lack of meaningful economic activity if the corporation is merely transitory, engaging in absolutely no business activity for profit. The Court decided that Finance conducted meaningful business activity (concededly minimal activity, but business activity nonetheless). The 1% spread between borrowing rate and lending rate was apparently sufficient to establish the existence of a meaningful business activity and to decide that Finance was not a mere conduit (thereby distinguishing the case from Aiken). [22] It is not entirely clear how much business must be done in order to pass the economic-substance test. Is any degree of business activity sufficient, or must that activity be meaningful? [23] The former option seems quite liberal, as any activity, [24] however insignificant, would grant full access to the treaty benefits, regardless of the amount of tax involved. On the other hand, requiring that the activity must be meaningful could result in uncertainty, as it is difficult to determine what is meant by this criterion. [25] Assuming that tax treaty benefits should be limited to those transactions that benefit the economic relationship of the contracting states and stimulate reciprocal trade between those states (see supra), the meaningful character of the activity should most likely be verified by comparing the tax benefit sought to the economic importance of the transaction. Obviously, this is a difficult assessment. An economic analysis could perhaps provide some guidance. Similarly, as Professor Warren has noted, a pre-tax profit requirement involves an inherent dilemma: either it is arbitrary or it is logically incoherent. [26] If the doctrine only requires there to be a pre-tax profit, however small, then it is arbitrary because a trivial economic profit will validate a transaction that may be dominated by tax

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considerations, whereas a very small economic loss will invalidate the same transaction. On the other hand, if the doctrine requires more than a trivial pre-tax profit, one would most likely have to consider the amount of profits which the market would command if no tax benefits were involved. However, this position is logically incoherent because it ignores the fact that capital markets take preferential tax treatment into account in setting relative prices. Finally, any intermediate position such as requiring a reasonable pre-tax return would also be based on an arbitrary criterion.

3. Limitation-on-benefits clauses in tax treaties

LOB clauses are tax treaty provisions that specifically deal with treaty shopping by setting out the rules by which the contracting states confine the treaty benefits to taxpayers that have a sufficient economic nexus with a contracting state. [27] Early LOB clauses generally denied treaty benefits where entities were formed with the principal purpose of taking advantage of the treaty benefits. [28] Because of the difficulty of applying rules based on taxpayers subjective intent, later LOB clauses were generally based on objective criteria, such as the percentage of ownership in the entity by residents of third states (the qualified-resident criterion). [29] Gradually, the criteria used in LOB clauses have grown increasingly sophisticated. For instance, the LOB provision in the 2006 US Model first lists a number of taxpayers who are entitled to the treaty benefits (qualified residents) and subsequently provides for an alternative test for qualifying items of income, regardless of whether the taxpayer meets the criteria. [30] The first test, concerning qualified residents, differs according to whether the taxpayer is an individual, a listed company, a non-listed company, etc. As regards non-listed companies, a two-part ownership and base erosion test is applied. First, at least 50% of the shares (or other beneficial interests) in the company must be owned for at least half of the taxable year by residents entitled to treaty benefits. Secondly, less than 50% of the companys gross income for the taxable year is paid or accrued, directly or indirectly, to persons not entitled to treaty benefits in the form of payments that are deductible in the companys state of residence (excluding arms-length payments in the ordinary course of business). [31] A second, alternative test in this LOB clause concerns qualifying items of income. Under this test, treaty benefits are also granted to residents of a contracting state with respect to an item of income derived from the other state if the resident actively conducts a trade or business in his home state, [32] and the income derived from the other contracting state is derived in connection with or is incidental to that trade or business. [33] This provision allows testing the economic connection of the taxpayer to the claimed country of residence, which is ultimately the core issue in treaty shopping cases. Despite this shift towards the use of objective elements, several modern tax treaties contain (objective) LOB provisions that are supplemented with or replaced by subjective elements. For instance, the LOB clause in the US Model provides that, if neither of the two tests referred to above is met, the competent authority may nevertheless grant the treaty benefits if the arrangement did not have as one of its principal purposes the obtaining of benefits under the treaty. [34] Similarly, the CanadaUK treaty refuses treaty benefits in respect of dividends, interest and royalties where it was the main purpose or one of the main purposes of any person concerned with [the transaction] to take advantage of the relevant treaty Article. [35] As a final example, the Belgian Model Convention provides as follows: a resident of a Contracting State shall not receive the benefit of any reduction in or from tax provided for in the Convention by the other Contracting state if the main purposes of such resident or a person connected with such resident was to obtain the benefits of the Convention. [36] Such exceptions serve to counter situations where the objective test is met, but where the tax motive is so distinct that it outweighs the economic nexus (e.g. where tax benefit is out of all proportion to the economic importance of the transaction). Obviously, the application of such subjective tests may lead to considerable difficulties in practice, as it is exceedingly difficult to demonstrate, for instance, that an arrangement has been entered into for the main purposes of taking advantage of a particular treaty article. Therefore, the question arises whether the addition of a subjective test in the tax treaty is advisable. In other words, should a taxpayer be granted treaty benefits as soon as the objective test is met i.e. when there is a sufficient economic nexus with the purported state of residence or should the treaty benefits also be warranted by the taxpayers intentions? From a purely economic perspective, it could be argued that subjective tests are not necessary: if the economic nexus is sufficiently strong, the treatys objective of stimulating reciprocal trade and business has been met, meaning that the taxpayer should be entitled to treaty benefits. Of course, there will be situations where the tax motive outweighs the economic nexus. However, the introduction of a subjective test is not the only possible method of dealing with such situations. Particularly, one could argue that the tax benefit resulting from a transaction and the economic importance of that transaction must be proportionate, i.e. that the economic nexus must be sufficient to warrant treaty protection. Proportionality is an objective, rather than a subjective test, but it nevertheless may cause some practical difficulties, especially with regard to measuring whether both aspects are in proportion.

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It is clear that drafters of LOB provisions need to strike a delicate balance between the prevention of avoidance and the safeguarding of legal certainty. As mentioned earlier, uncertainty may cause both an increase in avoidance and a decrease in FDI. It is therefore necessary that LOB clauses, and anti-abuse provisions in general, offer the taxpayer rules that are sufficiently clear, so that it is possible to know in advance whether treaty benefits will be available for a certain transaction. On the other hand and despite this need for certainty the most pressing issue is arguably the need to ensure that there is a sufficient economic connection between the taxpayer and his claimed country of residence. This cannot be decided on purely formalistic grounds: the meaningfulness of the business must be assessed on the basis of all facts and circumstances. Once again, the question thus arises when an economic connection is sufficiently strong to justify the grant of the treaty benefits. Once again, it seems that an economic analysis might provide guidance.

4. The beneficial ownership requirement in tax treaties

Pursuant to Arts. 10-12 of the OECD Model, the source state of dividends, interest and royalties is only required to grant a reduction or exemption from withholding tax where the beneficial owner of the income is a resident of the other contracting state. This requirement was introduced as an anti-abuse tool, particularly with respect to treaty shopping structures involving interposed conduit entities. [37] However, it is not entirely clear how the beneficial-ownership requirement should be interpreted. The case law dealing with this issue is scarce and divergent. Broadly speaking, two contrasting interpretations can be identified. First, a liberal approach is possible, where the ultimate beneficiary of the income, i.e. the person who reaps the economic benefits, is the beneficial owner, even if the income has passed through one or more conduit entities. Accordingly, an interposed conduit entity that receives the income in its own name and for its own account, but passes it on to the ultimate beneficiary, cannot be considered to be the beneficial owner. A second, narrow approach analyses the underlying contracts from a legal perspective in order to verify whether the interposed entity is acting in the capacity of agent or nominee. A number of criteria can be taken into account in this analysis, e.g. whether the interposed entity has free disposal of the income, whether the entity bears the risk associated with the transaction, etc. The Indofood case illustrates the importance of these divergent interpretations. An Indonesian company (the parent) wanted to issue loan notes. However, it would have been expensive in tax terms for the parent to issue these notes, because Indonesia levied a withholding tax of 20% on interest. In order to mitigate the tax burden, the notes were issued by a Mauritian subsidiary (the subsidiary) of the parent and on the same day, a loan agreement was concluded by which the subsidiary undertook to provide the proceeds of the notes to the parent and the parent undertook to pay interest to the subsidiary to enable it to fulfil its interest obligations under the notes. Under the tax treaty between Indonesia and Mauritius, the withholding tax on the interest paid by the parent to the subsidiary was limited to 10%. Moreover, the interest paid by the subsidiary to the noteholders was exempt from tax under Mauritian tax law. Three years later, the treaty between Indonesia and Mauritius was terminated, as a result of which the interest paid by the parent to the subsidiary would be subject to the 20% withholding tax in Indonesia. However, there was a provision in the terms of the loan notes, pursuant to which a change of law causing the rate of withholding tax to increase such as the termination of the IndonesiaMauritius tax treaty entitled the subsidiary to repay the notes at par, unless the subsidiary could take reasonable measures to avoid this increase. The subsidiary thus informed the noteholders that it would repay the notes early, but the noteholders refused to be paid at par since their notes were standing at a premium. According to the noteholders, it was possible for the subsidiary to take reasonable measures in order to avoid the increased withholding tax rate: a Netherlands company (Newco) could be interposed between the parent and the subsidiary in order to benefit from the tax treaty between Indonesia and the Netherlands. Pursuant to the provisions of that treaty, the interest paid by the parent to Newco would be exempt from withholding tax. Moreover, the interest could then be paid to the subsidiary and subsequently to the noteholders without attracting withholding tax, as neither the Netherlands nor Mauritius withheld tax on these payments. The parent asked the Indonesian tax authorities whether this proposed restructuring was acceptable. The tax authorities replied that the exemption from withholding tax under the NetherlandsIndonesia tax treaty could not be applied as Newco would not be the beneficial owner of the interest. According to the tax administration, the term beneficial owner means the actual owner of the interest income who truly has the full right to enjoy directly the benefits of that interest income. The subsidiary thus refused to implement the proposed restructuring. As the noteholders disagreed with the position taken by the tax authorities, the case was ultimately brought before the High Court. [38] On the basis of a legal analysis, the High Court decided that Newco would be the beneficial owner of the interest. The High Court first noted that there were two loan agreements: between the subsidiary and the noteholders, and between the parent and the subsidiary. Even though the subsidiary met its obligations to the noteholders from the interest it received from the parent, it was in no sense a trustee or fiduciary for the noteholders of the interest it received. The notes constituted direct, general and unconditional obligations of the subsidiary, i.e. these obligations were independent from the payment of interest by the parent under the second loan

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agreement. If the subsidiary were to become insolvent, undistributed interest received from the parent would form part of the assets of the subsidiary available to be distributed to its creditors generally including the noteholders pari passu. The proposed restructuring would transfer the rights and obligations of the subsidiary under these loan agreements to Newco. The High Court thus concluded that Newco, just as the subsidiary, would not be a nominee or agent for any other party and, not being any sort of trustee or fiduciary, [would] have power to dispose of the interest when received as it wishes, although it [would] be constrained by its contractual obligation to the [parent] to apply the proceeds of the interest payments in performance of those obligations. [39] Moreover, the High Court noted that, by contrast to the subsidiary, there was a spread between the rate of interest received by Newco and the interest which it paid out. In conclusion, the High Court held that Newco would be the beneficial owner of the interest under the proposed structure. Put briefly, the High Court arrived at its conclusion by applying a legal analysis to the underlying agreements, thereby verifying whether the subsidiary and Newco acted as a nominee, agent, fiduciary, etc. for any other party. An important aspect of the Courts line of reasoning is the risk-analysis: what would happen in the case of insolvency of the recipient of the income, before paying on the income to the ultimate beneficiary? If the ultimate beneficiary (i.e. the noteholders in the present case) has a direct claim on the undistributed interest, then that party is the beneficial owner of the income. On the other hand, if the undistributed interest would form part of the assets of the recipient available to be distributed to its creditors generally including the ultimate beneficiary then the recipient is the beneficial owner. The High Court decision was later reversed by the Court of Appeal. [40] According to the Court of Appeal, the High Court had misunderstood the facts of the case. First, the Court of Appeal noted that there was no interest spread between the borrowing and lending rate. The parent only paid handling charges to Newco. Moreover, Newco was in practice ignored and the payment was made directly from the parent to the noteholders. Finally, the parent had guaranteed to the noteholders payment of all sums due under the note conditions. According to the Court of Appeal, the concept of beneficial ownership is incompatible with that of the formal owner who does not have the full privilege to directly benefit from the income. [41] The subsidiary (or Newco, in the proposed structure) does not have such full privilege: it was bound to pay on to the noteholders the income it received from the parent because it was precluded from finding the money from any other source by the note conditions. The Court of Appeal then notes that the beneficial-ownership requirement is plainly not to be limited by so technical and legal an approach. [42] The substance of the matter must therefore be taken into account. Particularly, in both commercial and practical terms, the subsidiary was (and Newco would have been) bound to pay on to the noteholders that which it received from the parent. As mentioned earlier, the payment was in practice made directly from the parent to the noteholders and the parent also guaranteed payment of all sums due under the note conditions. Accordingly, it was impossible to conceive of any circumstances in which either the subsidiary (or Newco) could derive any direct benefit from the interest payable by the parent, except by funding its liability to the noteholders (or, in the case of Newco, to the subsidiary). However, this was not the full privilege needed to qualify as the beneficial owner, rather the position of the subsidiary and Newco was that of an administrator of the income. [43] Finally, this conclusion was held to be consistent with the object and purpose of the applicable tax treaties: the avoidance of double taxation (double taxation could not arise, as neither the subsidiary nor Newco made any profit) and the prevention of tax evasion. In contrast to the High Courts narrow approach, the Court of Appeal thus takes a broad approach to the interpretation of the beneficial-ownership requirement. The fact that the income was entirely used to fund a liability to a third party implied that the recipient did not have the full privilege to directly benefit from the income. Therefore, the recipient was not the beneficial owner of the income. It is interesting to compare these different lines of reasoning to the approach taken in the Prvost case. All of the shares in Prvost, a Canadian resident company, were held by a company resident in the Netherlands (the Holding). All of the shares in the Holding were held by Volvo, a company resident in Sweden, and Henlys, a company resident in the United Kingdom. Prvost paid dividends to the Holding, thereby withholding Canadian source tax which was reduced to 5% under the CanadaNetherlands tax treaty. Volvo and Henlys were parties to a shareholders agreement which provided that at least 80% of the profits of Prvost and the Holding and their subsidiaries (the Group) was to be distributed to the shareholders. The distribution of these profits was subject to the Group having sufficient financial resources to meet its normal and foreseeable working capital requirements at the time of payment unless the shareholders otherwise agreed. Amounts were to be distributed by way of dividend, return of capital or loan. The distribution for a fiscal year was to be declared and paid to shareholders as soon as practicable after the end of the fiscal year. The board of directors of the Holding was to take reasonable steps to procure that dividends or other payments were declared by Prvost or other steps were taken to enable the Holding to make payments of dividends or return of capital or that any sums loaned by shareholders were repaid. The directors of Prvost were also directors of the Holding. The Holding had no physical office or employees in the Netherlands or elsewhere. The Holdings registered office was in the offices of a Netherlands resident management company. The management company was allowed to transact business on a limited scale on behalf of the Holding and to pay interim dividends on its behalf to its shareholders.

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According to the Canadian tax authorities, the Holding was not the beneficial owner of the dividends with the result that the reduced withholding rate of 5% could not be applied. The tax authorities argued that the Holding was acting as a mere conduit or funnel in favour of Volvo and Henlys upon receiving dividends from Prvost (because the provisions of the CanadaNetherlands tax treaty were more favourable than the provisions of the CanadaUK treaty and the CanadaSweden treaty). The Tax Court dismissed this argument. [44] According to the Tax Court, the beneficial owner of dividends is the person who receives the dividends for his own use and enjoyment and assumes the risk and control of those dividends. The beneficial owner is the person who enjoys and assumes all the attributes of ownership. Put briefly, the dividend is for the owners own benefit and this person is not accountable to anyone for how he or she deals with the dividend income. Moreover, when corporate entities are concerned, one does not pierce the corporate veil unless the corporation is a conduit for another person and has absolutely no discretion as to the use or application of funds put through it as conduit, or has agreed to act on someone elses behalf pursuant to that persons instructions without any right to do other than what that person instructs it. [45] The Tax Court notes that this is not the relationship between the Holding and its shareholders. Even though the Holding had no physical office or employees in the Netherlands or elsewhere, and had mandated to a management company the transaction of its business and the payment of interim dividends on its behalf to Volvo and Henlys, there was no evidence that the dividends from Prvost were ab initio destined for Volvo and Henlys with [the Holding] as a funnel of flowing dividends from Prvost. [46] Moreover, the Holding was not party to the shareholders agreement. Consequently, neither Volvo nor Henlys could take action against the Holding for failure to follow the dividend policy described in that agreement. Finally, the Holding was the registered owner of the Prvost shares. It paid for the shares and it owned them for itself. When dividends were received by the Holding in respect of these shares, the dividends were the property of the Holding. Until such time as the management board of the Holding declared an interim dividend and the dividend was approved by the shareholders, the funds represented by the dividend continued to be property of, and were owned solely by, the Holding. The dividends were an asset of the Holding and were available to its creditors. Accordingly, no other person other than the Holding had an interest in the dividends received from Prvost. [47] In other words, the Holding was not under any contractual obligation to transfer any amount of its profits to Volvo and Henlys. Unlike the parent in Indofood, Volvo and Henlys did not even have an action against the Holding for the payment of an amount equal to the amount of dividends received. In contrast to the broad approach taken by the Court of Appeal in Indofood, the Tax Court in Prvost thus gives a narrow interpretation to the beneficial ownership concept. This approach was later confirmed on appeal by the Federal Court of Appeal. [48] This lack of a uniform approach obviously gives rise to uncertainty. International trade and financing requires an internationally accepted definition of the beneficial ownership concept. A possible approach might be to apply the narrow Prvost interpretation, which only aims at preventing the most obvious treaty shopping structures. We strongly reject the idea that as the OECD Model fails to define the term beneficial owner, it can be construed in accordance with the domestic law of the state applying the treaty, i.e. the source state. [49] This is an open invitation to widely divergent interpretations of the term beneficial owner that may go well beyond its legal meaning. In this respect, reference should be made to a Circular issued by the Chinese State Administration of Taxation (SAT), which illustrates the risks of an overly broad interpretation. In Circular 601, issued on 27 October 2009, the SAT gives a definition of the beneficial ownership concept for the purpose of Chinas tax treaties. [50] According to the Circular, the beneficial owner is any person who owns or has control and dominion over the income or the rights or assets that may give rise to such income. The beneficial owner must also be engaged in substantial business activities (e.g. manufacturing, distribution or management) and an agent or a conduit entity does not qualify as the beneficial owner. Conduit entities are defined in the Circular as entities incorporated for the purpose of the evasion or reduction of tax, the transfer or the accumulation of income. The Circular then lists a number of factors indicating that the recipient of income is not the beneficial owner. The taxpayer seeking to qualify as the beneficial owner of the income is required to demonstrate that these negative factors are not present. The Circular does not list positive factors, nor does it indicate whether a single negative factor may be decisive or whether different factors should be weighed. The following negative factors are listed: - the recipient has the obligation to distribute all or a substantial part of the income (e.g. 60%) to a third-country resident within a determined period; - the recipient does not undertake any other business activities apart from holding the investment in respect of which the income is derived; - the recipients assets, size and personnel are disproportionately small to the income derived; - the recipient does not have the right to dispose of the assets or does not assume the risks of ownership; - the income is not taxed, or is taxed at a low effective rate, in the recipients home state; and -

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the recipient has entered into a back-to-back agreement with terms similar to those of the agreement in respect of which the income is derived. This interpretation goes well beyond the traditional interpretation of the beneficial ownership concept. For instance, it is unclear why the level of taxation imposed in the recipients home state should affect his position as the beneficial owner. Similarly, the absence of other business activities or the proportionality of the recipients size to the income in question do not exclude a priori that the recipient is the beneficial owner. It seems that the interpretation given in the Circular is intended to function as a broad substance over form tool against treaty shopping, rather than merely giving an appropriate definition of the beneficial ownership concept. Art. 3(2) of the OECD Model makes it clear that the domestic law meaning of undefined treaty terms is not to be used where the context requires otherwise. There are a number of reasons why the domestic law meaning should not be used here. First, in many countries, and in particular in civil law countries, the term beneficial owner has no meaning at all. As a result, interpreting the term according to domestic law does not offer a solution. Moreover, even when there is a domestic law definition of the term, it may be inadvisable to use it in the interpretation of the treaty. The term has been included in the OECD Model particularly to prevent treaty shopping. Where a treaty contains a provision to counter its improper use, the prevention of such use should as much as possible be achieved through the common interpretation of that term between the contracting states and, more generally, through a uniform interpretation by all states that include the term in their tax treaties in order to avoid treaty shopping. If each state is free to define the term beneficial owner in accordance with its domestic law, there is a significant risk that the meaning emerging from domestic law goes well beyond the ordinary meaning of the term used in the treaty. [51] Beneficial ownership is a legal term originating from common law and in particular from UK law. It was initially introduced to distinguish various forms of ownership. [52] The OECD introduced it in 1977 in the OECD Model without being capable of defining it. However, the Commentary at that time made it clear that an agent, nominee or another person collecting income for the account of a third party (e.g. a trustee) is not the beneficial owner of the income, the underlying idea being that the income is not allocated to them for tax purposes but to a third party that is the beneficial owner. That seems to be the correct approach. Later on, the term beneficial owner has started to live a life of its own for several reasons: - because of the lack of a treaty definition, states have interpreted the term according to their own domestic law meaning; - because of a lack of clarity as to whether the term has an autonomous treaty meaning, the case law is divergent (see supra); - the OECD Commentary on Arts. 10-12 elucidating the term beneficial owner in itself is open to interpretation; and - the 2003 change to the Commentary states that the term beneficial owner should not be interpreted in a narrow, technical sense. The ball is now back in the OECDs court. The term beneficial owner should be defined in the treaty, as a legal term excluding persons collecting income and to which such income is not allocated for tax purposes, such as agents, nominees and other persons collecting income for the account of a third party (see supra). Consequently, only the most obvious cases of treaty shopping are targeted. If contracting states wish to go further, they are free to include LOB clauses or other anti-abuse measures in their treaties.

5. Cost-benefit analysis of anti-avoidance measures

The negotiation and implementation of anti-avoidance measures particularly measures laid down in tax treaties, such as LOB provisions comes at a certain administrative cost. Ideally, the increase in tax revenue resulting from the application of the measures exceeds this cost. However, a lot of factors determine whether a measure is successful (i.e. cost-efficient) or not. As discussed above, the implementation of an anti-abuse measure does not automatically increase tax revenue. The change in the legal constellation brought about by this implementation might cause the market participants to change their behaviour, for instance because the measure creates new tax planning opportunities or because it increases the level of legal uncertainty. Moreover, market participants might even adapt their behaviour before the measure comes into force, because they anticipate a change in the states tax policy. As a result, it is very difficult to assess whether a measure is cost-efficient. It is insufficient to simply compare the states tax revenue before the introduction of the measure with the tax revenue afterwards, because such an analysis takes no account of a number of important factors, some of which have been touched upon above. An economic analysis of all the relevant facts and circumstances is therefore required in order to verify whether an anti-abuse measure is efficient.

6. Conclusion

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This overview suggests that international tax law, and in particular legal research concerning treaty shopping, may benefit from an economic perspective. First, even though there is a general assumption that tax treaties stimulate trade and investment between the contracting states, empirical evidence demonstrates that reality is more nuanced. Particularly the impact of uncertainty is often overlooked in this regard. As a result, there is a possibility that measures intended to curb abuse and increase tax revenue, actually have the opposite effect by deterring bona fide taxpayers from investing and inciting fraudulent taxpayers to be more aggressive. Secondly, it seems that the objective component of most anti-avoidance mechanisms hinges on the question whether there is an economic justification for granting the taxpayer the relevant tax benefits. In the context of treaty shopping, this should be interpreted against the backdrop of tax treaties stated objective of stimulating reciprocal trade. The question thus arises whether there is a universal threshold that must be met in order for tax treaty benefits to be available. In other words, is it possible to formulate an economic-substance test to replace the beneficial-ownership requirement, LOB provisions, etc.? Assuming that tax treaties should only be applied to situations that further the economic objective sought by the treaty, this test could be seen as an implicit antiabuse mechanism, inherent in all tax treaties and intended to confine treaty application to situation where a sufficient economic nexus warrants it. On this basis, it could be argued that there is an underlying principle of tax treaty interpretation that denies the treaty benefits where the taxpayer has made improper use of the treaty. [53] This would allow for a direct assessment of the economic justification of tax treaty access, without needing to resort to indirect methods such as LOB provisions or beneficial-ownership requirements. Finally, the question arises whether anti-avoidance measures should be concerned with subjective aspects. As mentioned earlier, most anti-avoidance measures (at least in their objective component) require there to be a sufficient economic nexus before granting the tax benefits in question. On the other hand, subjective tests create uncertainty, and uncertainty seems to be the most important FDI-deterrent aspect in the context of tax treaties. Consequently, it could be argued that an objective test is sufficient to safeguard the economic purpose of tax treaties, while a subjective test only hinders this purpose. 1. 2. 3. OECD Commentary 2008, Art. 1, Para. 9.5. See OECD Commentary 2008, Art. 1, Paras. 11 et seq. See e.g. the Introduction to the OECD Commentary 2008, Para. 1, in which it is stated that the main purpose of the OECD Model Tax Convention is to remove the obstacles that double taxation presents to the development of economic relations between countries, thus reducing the harmful effects [of double taxation] on the exchange of goods and services and movements of capital, technology, and persons. See also Van Weeghel, S., Improper use of tax treaties, Series on International Taxation, No. 19 (The Hague: Kluwer Law International, 1997), p. 116. E.g. Blonigen, B.A. and R.B. Davies, The Effects of Bilateral Tax Treaties on U.S. FDI Activity, 11 International Tax and Public Finance 5 (2004), p. 601; Davies, R.B., Tax Treaties and Foreign Direct Investment: Potential versus Performance, 11 International Tax and Public Finance 6 (2004), p. 775; Egger, P., M. Larch, M. Pfaffermayr and H. Winner, The Impact of Endogenous Tax Treaties on Foreign Direct Investment: Theory and Evidence, 39 Canadian Journal of Economics 3 (2006), p. 901; Louie, H.J. and D.J. Rousslang, Host-country Governance, Tax Treaties and US Direct Investment Abroad, 15 International Tax and Public Finance 3 (2008), p. 256; Davies, R.B., P. Norbck and A. Tekin-Koru, The Effect of Tax Treaties on Multinational Firms: New Evidence from Microdata, 32 The World Economy 1 (2009), p. 77. E.g. Blonigen, Davies, 11 International Tax and Public Finance 5 (2004), p. 601; Davies, 11 International Tax and Public Finance 6 (2004), p. 775; Egger, Larch, Pfaffermayr, Winner, 39 Canadian Journal of Economics 3 (2006), p. 901; Louie, Rousslang, 15 International Tax and Public Finance 3 (2008), p. 256. E.g. Blonigen, Davies, 11 International Tax and Public Finance 5 (2004), pp. 603-605; Davies, Norbck, Tekin-Koru, 32 The World Economy 1 (2009), pp. 78-79. Davies, Norbck, Tekin-Koru, 32 The World Economy 1 (2009), pp. 96 and 108. Weisbach, D., An Economic Analysis of Anti-Tax Avoidance Doctrines, 4 American Law and Economics Review 1 (2002), p. 88 (p. 107). See, for instance, the remarks made in Indian Supreme Court, 7 October 2003, Azadi Bachao Andolan, 263 ITR 706: In developing countries, treaty shopping is often regarded as a tax incentive to attract scarce foreign capital or technology. They are able to grant tax concessions exclusively to foreign investors over and above the domestic tax law provisions. In this respect, it does not differ much from other similar tax incentives given by them, such as tax holidays, grants, etc. Developing countries

4. 5.

6.

7. 8. 9. 10.

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need foreign investments, and the treaty shopping opportunities can be an additional factor to attract them. 11. 12. Davies, Norbck, Tekin-Koru, 32 The World Economy 1 (2009), p. 108. That is not to say that the treatys object and purpose should be the sole guiding principles in the interpretation process or that the treaty should be interpreted teleologically. Only where the treatys object and purpose are relevant for the interpretation, should this question come up for discussion. For an extensive analysis of whether tax treaties should be interpreted teleologically, see De Broe, International Tax Planning and Prevention of Abuse, Doctoral Series, Vol. 14 (Amsterdam: IBFD Publications BV, 2008), pp. 247-255. For an extensive analysis of the possibility to apply domestic anti-avoidance rules to tax treaties, see De Broe, International Tax Planning and Prevention of Abuse (2008), pp. 377-459. E.g. United States Supreme Court, 7 January 1935, Gregory v. Helvering, 293 U.S. p. 465, (p. 469-470); United States Court of Appeal, Federal Circuit, 12 July 2006, Coltec Industries, Inc. v. United States, 454 F.3d p. 1340, (p. 1352). E.g. United States Court of Appeals, Second Circuit, 22 July 1966, Goldstein v. Commissioner, 364 F.2d 734. See also Cooper, G., The Design and Structure of General Anti-tax Avoidance Regimes, 63 Bulletin for International Taxation 1 (2009), p. 26 (p. 30) who refers to a US proposal (which was never enacted) to introduce a quantitative anti-avoidance test. Under this test, avoidance would have been defined as any transaction in which the reasonably expected pre-tax profit (determined on a present value basis, after taking into account foreign taxes as expenses and transaction costs) of the taxpayer from the transaction is insignificant relative to the reasonably expected net tax benefits (i.e., tax benefits in excess of the tax liability arising from the transaction, determined on a present value basis) of the taxpayer from such transaction. United States Supreme Court, 7 January 1935, Gregory v. Helvering, 293 U.S. p. 465, (p. 469). E.g. United States Court of Appeals, Fourth Circuit, 7 January 1985, Rices Toyota World, Inc. v. Commissioner, 752 F.2d p. 89, (pp. 91-92). In the words of Gregory v. Helvering, quoted above: whether what was done, apart from the tax motive, was the thing which the [treaty] intended. It should be stressed once again that object and purpose of the treaty are not the sole guiding principles in tax treaty interpretation; see note 12. United States Tax Court, 5 August 1971, Aiken Industries v. Commissioner, 56 TC 925. See Art. 2(2) of the USHonduras treaty. United States Court of Appeals, 6 June 1997, Northern Indiana Public Service Company v. Commissioner, 115 F.3d 506. Compare Revenue Ruling 84-152, 1984-2 C.B.: a US subsidiary of a Swiss company borrowed funds from a Netherlands Antilles subsidiary at an annual interest rate of 11%. In turn, the Netherlands Antilles subsidiary borrowed from the Swiss parent at an annual rate of 10%. According to the IRS, the interest paid by the US subsidiary was not exempt under the United StatesNetherlands tax treaty because the intermediary lacked sufficient business or economic purpose to overcome the conduit nature of the transaction, even though it can be demonstrated that the transaction may serve some business or economic purpose (emphasis added). Compare US Supreme Court, 14 November 1960, Knetsch v. United States, 364 US 361: [the taxpayers] transaction with the insurance company did not appreciably affect his beneficial interest except to reduce his tax (emphasis added). Or, in the case of a back-to-back loan, any spread. It could furthermore be suggested that meaningful should be interpreted differently depending on the nature of the activity involved. For instance, the degree of meaningfulness of industrial activities might differ from that of holding activities. Warren, A., The Requirement of Economic Profit in Tax Motivated Transactions, 59 Taxes - The Tax Magazine 12 (1981), p. 985 (p. 987). For an extensive overview, see Borrego, F., Limitation on benefits clauses in double taxation conventions, Eucotax Series on European Taxation, Vol. 12 (The Hague: Kluwer Law International, 2006), pp. 113 et seq. See Kornikova, A., Solving the Problem of Tax-treaty Shopping through the Use of Limitation on Benefits Provisions, 8 Richmond Journal of Global Law and Business 2 (2008), p. 249 (p. 279).

13. 14.

15.

16. 17. 18.

19. 20. 21. 22.

23.

24. 25.

26. 27.

28.

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29. 30. 31. 32.

E.g. Art. 16 of the 1981 US Model, which imposed a 75% ownership requirement. Art. 22 of the 2006 US Model. A similar provision is proposed in OECD Commentary 2008, Art. 1, Para. 20. Compare OECD Commentary 2008, Art. 1, Para. 17. Other than the business of making or managing investments for the residents own account, unless these activities are banking, insurance or securities activities carried on by a bank, insurance company or registered securities dealer. Moreover, if a resident of a contracting state derives an item of income from a trade or business activity conducted in the other contracting state, the income is only considered to be incidental to or derived in connection with the trade or business in the home state if the trade or business activity carried on in the home state is substantial in relation to the trade or business activity carried on in the other contracting state. Art. 22(4) of the US Model. Arts. 10(7), 11(11) and 12(8) of the CanadaUK treaty, respectively. Similar provisions are proposed in the OECD Commentary 2008, Art. 1, Para. 21.4. Art. 27 of the Belgian Model Convention. See OECD Commentary 2008, Art. 1, Para. 10; OECD Commentary 2008, Art. 10, Paras. 12-12.2 and OECD Committee on Fiscal Affairs, Double Taxation and the Use of Conduit Companies, Para. 14. High Court (Chancery Division), 7 October 2005, Indofood International Finance Limited v. JPMorgan Chase Bank, N.A., London Branch [2005] EWHC 2103 (Ch). The terms of the notes provided that English law governed the notes and that the English courts had exclusive jurisdiction to settle any relevant dispute. High Court (Chancery Division), 7 October 2005, Indofood [2005] EWHC 2103 (Ch), Para. 46. Court of Appeal (Civil Division), 2 March 2006, Indofood International Finance Limited v. JPMorgan Chase Bank, N.A., London Branch [2006] EWCA Civ 158. Court of Appeal (Civil Division), 2 March 2006, Indofood [2006] EWCA Civ 158, Para. 42. Given the scope of this paper, we will not discuss the sources used by the Court in arriving at this definition (e.g. the Court seems to find some inspiration in the Indonesian substance-over-form doctrine). Court of Appeal (Civil Division), 2 March 2006, Indofood [2006] EWCA Civ 158, Para. 43. Court of Appeal (Civil Division), 2 March 2006, Indofood [2006] EWCA Civ 158, Para. 44. Tax Court of Canada, 22 April 2008, Prvost Car Inc. v. The Queen [2008] TCC 231. Tax Court of Canada, 22 April 2008, Prvost [2008] TCC 231, Para. 100. Tax Court of Canada, 22 April 2008, Prvost [2008] TCC 231, Para. 102. Tax Court of Canada, 22 April 2008, Prvost [2008] TCC 231, Paras. 103-105. Federal Court of Appeal, 26 February 2009, The Queen v. Prvost Car Inc. [2009] 3 CTC 160. Art. 3(2) of the OECD Model. See Sussman, L., A. Choi, C. Huang, C. Zhou and F. Chen, China Enforces Anti-Treaty Shopping Legislation, 56 Tax Notes International 7 (2009), p. 479; McKee, The Concept of Beneficial Ownership in Chinas Treaties, 57 Tax Notes International 1 (2010), p. 59. De Broe, International Tax Planning and Prevention of Abuse (2008), pp. 667-675. Avery Jones, J., The Origins of Concepts and Expressions Used in the OECD Model and their Adoption by States, 60 Bulletin for International Taxation 6 (2006), p. 246. See also Ward, D., Abuse of Tax Treaties, Intertax 4 (1995), p. 176.

33.

34. 35. 36. 37. 38.

39. 40. 41.

42. 43. 44. 45. 46. 47. 48. 49. 50.

51. 52. 53.

Citation: F. Barthel et al., Tax Treaties: Building Bridges between Law and Economics (M. Lang et al. eds., IBFD 2010), Online Books IBFD (accessed 2 Aug. 2013).

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