Steps to avert treaty abuse makes treaty access more taxing!
Tax treaties serve to reduce or eliminate double taxation which, if unrelieved, would be a significant barrier to cross-border trade and investment. At the same time, there was need felt to protect against granting of treaty benefits in inappropriate circumstances.
In this background, the work of the OECD and G20 on Base Erosion and Profit Shifting (BEPS) on preventing treaty abuse (Action 6), assumes significance. Broadly, the OECD BEPS Report on Action 6 (released in September 2014 with discussion drafts on follow up work published in November 2014 and May 2015, with the final version to be released soon) seeks to address treaty abuse in the following two scenarios;
(i) taxpayer tries to circumvent limitations provided by treaties itself and (ii) taxpayer tries to abuse domestic tax laws by using treaties.
The Report makes several recommendations for changes to the OECD Model Tax Convention (MC) and related Commentary as well as changes to domestic law provisions to address treaty abuse scenarios.
One of the strategies of treaty abuse falling in the first category is ‘treaty shopping’. It refers to a situation where a person who is otherwise not entitled to benefits of a particular treaty makes use of a legal person established in that treaty jurisdiction for the purpose of enjoying treaty benefits which it could not otherwise avail.
The Report recommends a three pronged approach to address treaty shopping. First, inclusion in the title and preamble of a treaty, a clear statement indicating an intention to avoid opportunities for low or no taxation through tax evasion or avoidance including treaty shopping arrangements (title and preamble amendment). Second, inclusion of an objective Limitation of Benefits (LOB) rule, which requires a person (being a resident of one of the treaty countries) applying the benefits under a treaty to be a qualified person as determined by the LOB rule. These provisions are common in US treaties and also finds place as Article 24 of the India US treaty. Third, inclusion of a general anti-abuse rule (Principle Purpose Test rule or the PPT rule), as per which a treaty benefit cannot be availed, if one of the principal purposes of that transaction is to obtain treaty benefit. This is similar to the “main purpose” test found in UK treaties. This rule has been incorporated in the India UK treaty by way of a Protocol signed in 2012.
The Report acknowledges that while inclusion of title and preamble as above is necessary, adoption of both types of provisions (LOB plus PPT rule) together, might not be appropriate for all countries. Accordingly, it recommends adoption of a minimum standard. This is met if countries adopt either (A) simplified LOB provision and PPT rule, (B) PPT rule, or (C) LOB rule supplemented by PPT rule applicable to conduit financing arrangements or domestic anti-abuse rules/ judicial doctrines that achieve a similar result.
As early as in 2003, the Supreme Court (SC) of India in the case of Union of India v. Azadi Bachao Andolan (263 ITR 706) held that that there are no disentitling conditions prohibiting a resident of a third country to derive benefits of the India Mauritius treaty. However, in the case of Vodafone (341 ITR 1) the SC observed that, the Tax Authority would not be precluded from denying treaty benefits in case it is established that the Mauritius company is without any commercial substance, or is interposed with a view to avoid tax. India has since introduced strict documentation requirements to apply for treaty benefits.
Nevertheless, India’s treaties, as a norm, include fiscal evasion in the title and preamble; a notable exception is the India Russia treaty which has economic development as one of its objectives instead. Further, nearly 40 of India’s treaties contain anti-abuse provisions in the form of an LOB article. Some of these LOB articles contain a rule that is comparable to the PPT rule (apart from the UK, India’s treaties with Bhutan, Columbia, Georgia, Iceland, Indonesia, Fiji, Finland, Kuwait, Luxembourg, Mayanmar, Malaysia, Malta, Mexico, Nepal, Norway, Poland, Sri Lanka, Saudi Arabia, UAE amongst others also contain a main purpose test rule).
While an objective LOB rule is welcome, the PPT rule is often criticised as being vague and subjective. Further, it is difficult to evaluate and administer in practice because it depends on the intent of the taxpayer. This leads to uncertainty in its application. One hopes that tax authorities take a co-ordinated and consistent approach in the administration of the PPT rule.
Anti-abuse provision in India’s treaties, do create challenges not only for investors investing in India but also Indian headquartered companies and other Indian residents who may need to access treaty benefits for income sourced from other jurisdictions. This difficulty is accentuated as many of India’s treaties provide for wide source country taxation rights. For example, service income is taxed under a separate fees for technical services (FTS) article, which is not present in the OECD or UN MC. The lower withholding tax rate provided for FTS, interest and royalties can be availed where the Indian resident is able to demonstrate that they do not fall foul of the anti-abuse provisions of the relevant treaty. The uncertainty is enhanced in cases where these anti-abuse provisions specifically provide that domestic anti-abuse rules will prevail over treaty provisions (example see India’s treaties with Columbia, Fiji, Georgia, Luxembourg, Malaysia, Malta, Saudi Arabia)
With an increasing number of countries already having general anti-abuse rules ( GAAR) in their domestic laws and many more jurisdictions following suit (example, European Union, Denmark, Egypt, Italy, Sweden, Spain and South Africa), treaty access is likely to be a challenge going forward. Therefore there is an urgent need to ensure that efforts to protect against the grant of treaty benefits in inappropriate circumstances do not interfere with the grant of such benefits in appropriate circumstances.
