Tax treaty access, a challenge going forward? – Impact of BEPS Action 6 on collective investment vehicles

In 2013, the Organisation for Economic Cooperation and Development (OECD) released a series of proposed tax measures for eliminating corporate tax structures that shift profits to foreign jurisdictions. This corporate tax practice is commonly referred to as base erosion and profit shifting or BEPS.

Towards this, the OECD and G20 countries have adopted a 15-point Action Plan to address BEPS. The BEPS project aims to create a single set of consensus-based international tax rules to protect tax bases of Governments while offering increased certainty and predictability to taxpayers. A key focus of this work has been to eliminate double non-taxation. This article focuses on Action 6 of the BEPS project dealing with developing a model tax treaty provisions that would grant treaty benefits only in appropriate circumstances and prevent treaty shopping with a specific focus on Collective Investment Vehicles.

Collective Investment Vehicles (CIVs): Treaty entitlement

A CIV, in simple terms, is an entity that allows investors to pool their money and invest the pooled funds in a broad based portfolio, instead of buying securities directly as individuals. Typically, a fund manager is appointed to manage the investments of the CIV.

One of the areas specifically discussed by OECD in Action 6 is granting treaty benefits to CIVs. The discussion on CIVs is limited to funds that are (a) widely-held, (b) hold a diversified portfolio of securities and (c) are subject to investor-protection regulation in the home country. From an Indian perspective, several FIIs/FPIs investing in India will qualify as CIVs. It is noted in the discussion draft that OECD will separately explore approaches for treaty entitlement of non-CIV funds such private equity funds, hedge funds or pension funds that do not meet the conditions of CIV.

CIVs provide an opportunity to investors to diversify their investment portfolio and risks without incurring substantial costs. There can be a situation where the investors in the CIV are residents of other countries (Country X). In such a situation, a key question that arises is whether such a CIV can claim benefits of tax treaty between the source country (Country Y) and the country in which the CIV is established (Country Z).

Currently, the determination of the eligibility of a CIV to treaty benefits is based on various factors such as the form of CIV (trust, company, etc), fiscal transparency (liability to pay taxes), beneficial ownership of the income, etc. Although the investor in a CIV has a right over his interest in the CIVs, the investor has no right to the underlying assets of the CIV. Typically, the manager of the CIV has the discretionary powers to manage the assets on behalf of the investors. In such a situation, a key question that arises is whether such a CIV can claim benefits of tax treaty between the source country (Country Y) and the country in which the CIV is established (Country Z).

Currently, the determination of the eligibility of a CIV to treaty benefits is based on various factors such as the form of CIV (trust, company, etc), fiscal transparency (liability to pay taxes), beneficial ownership of the income, etc. Although the investor in a CIV has a right over his interest in the CIVs, the investor has no right to the underlying assets of the CIV. Typically, the manager of the CIV has the discretionary powers to manage the assets on behalf of the investors. In such a situation, it has been advocated that the CIV should be entitled to treaty benefits on its own behalf.

Alternative approaches discussed by OECD

The September 2014 Report of OECD discusses a number of alternative provisions for granting treaty benefits to CIVs. On 22 May 2015, the OECD released a revised discussion draft (RDD) on Action 6 – Preventing Treaty Abuse under the BEPS project. The RDD mentions that the conclusions of the September 2014 Report also correspond to the various approaches included in OECD’s earlier report, The Granting of Treaty Benefits with Respect to the Income of Collective Investment Vehicles (the 2010 CIV Report) concerning the treaty entitlement of CIVs.

One of the approaches discussed is granting treaty benefits to a CIV ‘only to the extent’ of beneficial interest owned by investors of the country in which CIV is established. Given that the ownership of interests in CIVs change regularly, it is impractical for the CIV to collect such information ‘each time’ the CIV receives income. Hence, it has been suggested that such checks can be done on a ‘quarterly basis’ instead of daily basis.

To avoid the aforesaid practical challenge of periodic collection of information, it has also been provided that countries can evaluate if the ‘majority of the beneficial interests’ in the CIV are owned by investors of the country in which CIV is established.

Another possible view a country can adopt is to conclude that the fact that a ‘substantial proportion’ of the CIV’s investors are treaty-eligible is adequate protection against treaty shopping; and therefore, the CIV is eligible for treaty benefits with respect to ‘all income received’ (as against only proportionate).

A look-through approach has also been discussed in the context of CIVs with only specific investors. Further, in the case of publicly traded CIVs, where the shares are listed and regularly traded on exchanges, the same would be sufficient for claiming treaty benefits.

Where the CIV is subjected to a nil or low taxation in the home country, there can be a potential deferral of taxation if the CIV accumulates its income rather than distributing it. To mitigate such a situation, it has been suggested that countries can grant treaty benefits only to those CIVs that are required to regularly distribute earnings.

Proposal by OECD and implications

Given the peculiar features of a CIV, it has been proposed that there is a need for flexibility in approaches (instead of a single approach) in light of the variations in structures, investor bases and investment policies found across the range of CIVs.

OECD has also issued Treaty Relief and Compliance Enhancement (TRACE) report in 2013. The TRACE report provides a framework for sharing information of the investors in the CIVs (such as tax identification number, country of residency, etc) with the source country. It has also been agreed that the implementation of the TRACE report is important for the practical application of approaches discussed in the 2010 CIV Report.

OECD will finalise the RDD after considering public comments and is expected to release the final commentary on 5 October 2015. The Indian Government being a supporter of the BEPS project is likely to review the BEPS deliverable and evaluate the changes if any required in the tax treaties.

Currently CIVs are commonly set up in tax neutral jurisdictions so that there is no double taxation at the CIV level and at the investor level. The BEPS measures of restricting the treaty eligibility to CIVs would be serious cause for concern for CIVs. Further, from an Indian context, at times CIVs are set up in jurisdictions like Mauritius for investing in Indian securities. These CIVs are currently eligible to the benefits of the India Mauritius tax treaty. Most investors in these CIVs do not reside in Mauritius. Hence, it would important for these CIVs to see how India implements the measures of Action 6.

Summary

The RDD contains proposals that will be further developed in light of the comments received and subsequent discussions. The proposals in the RDD would have significant implications for global businesses especially CIVs in terms of their continuing access to treaty benefits. The Governments should take care that the new rules should not result in unwarranted compliance burdens or restrictions to legitimate cross-border activity. It is important for companies to continue to monitor the developments in this area and in the countries in which they operate and invest.