Anti-Treaty Shopping A Comparative Analysis of the U.S. and OECD Model Tax Conventions Duke University  Sanford School of ...
<ul><li>Model Tax Conventions </li></ul><ul><li>The OECD Model Tax Convention:   The OECD Model was developed by the Fisca...
<ul><li>Reasons for Concluding Tax Treaties </li></ul><ul><li>1. To Promote Exchanges of Goods and Services and the Moveme...
<ul><li>Reasons for Concluding Tax Treaties (cont’d) </li></ul><ul><li>Illustration 1(b): </li></ul><ul><li>Toyota, a Japa...
<ul><li>Reasons for Concluding Tax Treaties (cont’d) </li></ul><ul><li>There are two principal means adopted under tax tre...
<ul><li>Reasons for Concluding Tax Treaties (cont’d) </li></ul><ul><li>Prevention of Tax Avoidance and Evasion  (See Para....
<ul><li>Meaning of Treaty Shopping </li></ul><ul><li>Treaty shopping typically arises where a person (whether or not a res...
<ul><li>Meaning of Treaty Shopping (cont’d) </li></ul><ul><li>Direct Conduit Structure </li></ul><ul><li>In the illustrati...
<ul><li>Meaning of Treaty Shopping (cont’d) </li></ul><ul><li>Stepping stone conduits  </li></ul><ul><li>The stepping ston...
<ul><li>Meaning of Treaty Shopping (cont’d) </li></ul><ul><li>Treaty shopping includes a situation where an individual who...
<ul><li>Why Treaty Shopping is Undesirable </li></ul><ul><li>Treaty benefits negotiated between two or more states are ext...
<ul><li>Anti-Treaty Shopping Measures in the U.S. Model Tax Convention </li></ul><ul><li>The United States has taken an ag...
<ul><li>Benefit Eligibility Tests Applicable to Companies  under the LOB Clause–  </li></ul><ul><li>1.  “Public  Company” ...
<ul><li>Benefit Eligibility Tests Applicable to Companies  under the LOB Clause–  </li></ul><ul><li>Public Company Test - ...
<ul><li>Benefit Eligibility Tests Applicable to Companies  under the LOB Clause–  </li></ul><ul><li>“ Public  Company”  Te...
<ul><li>Benefit Eligibility Tests Applicable to Companies  under the LOB Clause–  </li></ul><ul><li>“ Public  Company”  Te...
<ul><li>Public Company Test (Art. 22(2)(c)(i) & (ii)) – </li></ul>II. Treaty Shopping – The U.S. Approach Is the Principal...
<ul><li>Benefit Eligibility Tests Applicable to Companies  under the LOB Clause–  </li></ul><ul><li>2.  Ownership/Base Ero...
<ul><li>Benefit Eligibility Tests Applicable to Companies under the LOB Clause – </li></ul>II. Treaty Shopping – The U.S. ...
<ul><li>Benefit Eligibility Tests Applicable to Companies  under the LOB Clause–  </li></ul><ul><li>3. Trade or Business T...
<ul><li>Benefit Eligibility Tests Applicable to Companies  under the LOB Clause–  </li></ul><ul><li>3. Trade or Business T...
<ul><li>3. Active Business Test (Art. 22(3)(a)&(b)). </li></ul>II. Treaty Shopping – The U.S. Approach Is the Company or i...
<ul><li>Benefit Eligibility Tests Applicable to Individuals, Pension Funds, Charities and Like Institutions under the LOB ...
<ul><li>Benefit Eligibility Tests Applicable to Individuals, Pension Funds, Charities and Like Institutions under the LOB ...
<ul><li>Conduit Company Cases </li></ul><ul><li>A report of the OECD Committee on Fiscal Affairs, entitled “Double Taxatio...
<ul><li>Conduit Company Cases (cont’d) </li></ul><ul><li>2. The “Subject-to-tax” Approach </li></ul><ul><li>Under the subj...
<ul><li>Conduit Company Cases (cont’d) </li></ul><ul><li>To ensure that bona fide business transactions are not subject to...
<ul><li>Conduit Company Cases (cont’d) </li></ul><ul><li>4.  The “Exclusion” Approach </li></ul><ul><li>Certain types of c...
<ul><li>1.  Beneficial Ownership Requirement </li></ul><ul><ul><li>Both the U.S. and OECD Model Tax Conventions contain a ...
<ul><li>1.  Beneficial Ownership Requirement (cont’d) </li></ul><ul><ul><li>Profits – whether a taxpayer is entitled to th...
<ul><li>1. Beneficial Ownership Requirement (cont’d) </li></ul>II. Treaty Shopping – Shared Approaches SPV “ Issuer” Paren...
<ul><li>1. Beneficial Ownership Requirement (cont’d) </li></ul>II. Treaty Shopping – Shared Approaches SPV “ Issuer” SPV N...
<ul><li>1. Beneficial Ownership Requirement (cont’d) </li></ul>II. Treaty Shopping – Shared Approaches SPV “ Issuer” SPV N...
<ul><li>1. Beneficial Ownership Requirement (cont’d) </li></ul>II. Treaty Shopping – Shared Approaches SPV “ Issuer” SPV N...
<ul><li>2.  Place of Effective Management of Subsidiary Companies </li></ul><ul><ul><li>Claims to treaty benefits by subsi...
<ul><li>Key Differences Between the OECD & U.S. Approaches </li></ul><ul><li>In significant part, the approaches taken by ...
<ul><li>Treasury Department Technical Explanations to the U.S. Model Tax Convention (November 15, 2006). </li></ul><ul><li...
<ul><li>Thank You   </li></ul>
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Anti-Treaty Shopping: A Comparative Analysis of the U.S. and OECD Model Tax Conventions

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The presentation highlights the key approaches taken by the U.S. and the OECD to combat treaty shopping techniques and highlights key differences between those approaches.

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Anti-Treaty Shopping: A Comparative Analysis of the U.S. and OECD Model Tax Conventions

  1. 1. Anti-Treaty Shopping A Comparative Analysis of the U.S. and OECD Model Tax Conventions Duke University Sanford School of Public Policy - International Tax Program Presented By: Festus Akunobera, Esq. Partner, East Legal Services, Uganda akunobera@taxation.east.co.ug January 22, 2010
  2. 2. <ul><li>Model Tax Conventions </li></ul><ul><li>The OECD Model Tax Convention: The OECD Model was developed by the Fiscal Affairs Committee of the OECD and has been revised several times. The latest version was approved by the OECD Council on July 17, 2008. The OECD is a unique forum where the governments of 30 democracies work together to address the economic, social and environmental challenges of globalization. The OECD provides a setting where governments can compare policy experiences, seek answers to common problems, identify good practice and work to co-ordinate domestic and international policies. The OECD member countries are: Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. </li></ul><ul><li>The U.S. Model Tax Convention: The United States has developed its own model tax convention. The U.S. Model Tax Convention is in certain respects similar to the OECD Model Tax Convention, but certain aspects of the U.S. Model Tax Convention are materially different. The latest version was adopted by the United States on November 15, 2006. </li></ul><ul><li>The UN Model Tax Convention: The UN Model is premised on the desirability of promoting greater inflows of foreign investment to developing countries on conditions which are politically acceptable as well as economically and socially beneficial. The UN Model is often the developing countries’ starting point in treaty negotiations. </li></ul>I. Background
  3. 3. <ul><li>Reasons for Concluding Tax Treaties </li></ul><ul><li>1. To Promote Exchanges of Goods and Services and the Movement of Capital and Persons, by Eliminating International Double Taxation (See Para. 7 of the OECD Commentary to Article 1 of the OECD Model Convention). </li></ul><ul><li>Illustration 1(a): </li></ul><ul><li>Toyota, a Japanese multinational corporation, is engaged in manufacturing in the United States. Toyota derives income from its manufacturing operations in the United States. </li></ul><ul><li>Japan imposes income tax on its residents’ worldwide income. The United States imposes tax on income derived by foreign corporations from sources in the United States. </li></ul><ul><li>If there were no tax treaty between Japan and the United States, Toyota would incur U.S. tax on income derived from its manufacturing operations in the United States (i.e., U.S. sourced-based tax) and incur Japanese residence-based tax on income derived from its operations in United States. </li></ul>I. Background
  4. 4. <ul><li>Reasons for Concluding Tax Treaties (cont’d) </li></ul><ul><li>Illustration 1(b): </li></ul><ul><li>Toyota, a Japanese multinational corporation, is engaged in manufacturing in the United States. Automobiles manufactured in the United States are sold in Canada. </li></ul><ul><li>Assume that income derived from goods manufactured in the United States is treated as derived from sources in the United States. Assume also that income derived from sales of goods in Canada is treated as derived from sources in Canada. </li></ul><ul><li>Toyota is at risk of incurring U.S. source-based tax, Canadian source based tax and Japanese residence-based tax. </li></ul><ul><li>Would a treaty between the United States and Canada alleviate the double taxation problem as between Canada and the United States? – No. treaty benefits are available only to residents of contracting states, and in our illustration, Toyota is resident in neither the United States nor Canada. </li></ul>I. Background
  5. 5. <ul><li>Reasons for Concluding Tax Treaties (cont’d) </li></ul><ul><li>There are two principal means adopted under tax treaties to alleviate the double taxation problem: </li></ul><ul><li>The foreign tax credit method. If a resident of a contracting state (“State R”) incurs tax on income derived from sources in the other contracting state (“State S”), State R must, subject to limitations, permit its resident to reduce State R tax liability by the amount of State S income tax incurred on that income. </li></ul><ul><li>The exemption method. If a resident of State R derives income from State S sources, State R is, subject to limitations, required to exempt that income from State R tax. </li></ul><ul><li>Note: Most countries unilaterally grant an exemption or foreign tax credit under domestic law. </li></ul><ul><li>A unilateral credit or exemption may not be sufficient where both State R and State S consider income to be derived from domestic sources. A tax treaty alleviates this problem through what is called ‘re-sourcing’ (i.e., if State S imposes tax in accordance with the terms of the tax treaty, State R is required to treat the income as foreign source, notwithstanding the provisions of State R ’s domestic law). </li></ul>I. Background
  6. 6. <ul><li>Reasons for Concluding Tax Treaties (cont’d) </li></ul><ul><li>Prevention of Tax Avoidance and Evasion (See Para. 7 of the OECD Commentary to Article 1 of the OECD Model Convention). </li></ul><ul><li>Most tax treaties contain provisions for co-operation between tax administrations of contracting states through mutual assistance and exchange of information in the collection of taxes. </li></ul><ul><li>Tax administrations may also exchange other sensitive information related to tax administration and compliance improvement, for example risk analysis techniques or tax avoidance or evasion schemes. </li></ul><ul><li>Illustration </li></ul><ul><li>A State A corporation sells goods through a State C company to a State B company. The companies may or may not be associated. There is no convention between State A and State C, nor between State B and State C. Under the convention between State A and State B, State A, with a view to ensuring the correct application of the provisions of its domestic laws to the profits made by State A corporation, asks State B what price State B company paid for the goods. </li></ul>I. Background
  7. 7. <ul><li>Meaning of Treaty Shopping </li></ul><ul><li>Treaty shopping typically arises where a person (whether or not a resident of a Contracting State) acts through a legal entity created in a contracting state essentially to obtain treaty benefits that would not be available directly. </li></ul><ul><li>Treaty shopping is commonly accomplished through what are known as ‘conduit’ entities or special purpose vehicles. </li></ul><ul><li>The conduit company takes advantage of the treaty provisions under its own name in State S; economically, however, the treaty benefit goes to persons not entitled to use that treaty. </li></ul><ul><li>The conduit company is usually able to enjoy reduced withholding tax rates or exemption from capital gains tax in the source country. </li></ul>II. Treaty Shopping
  8. 8. <ul><li>Meaning of Treaty Shopping (cont’d) </li></ul><ul><li>Direct Conduit Structure </li></ul><ul><li>In the illustration below, instead of a U.S. person investing directly in a Ugandan company and incurring 15% withholding tax, the U.S. person invests through a Mauritius GBC structure. As such, the U.S. person is able to take advantage of the Uganda – Mauritius tax treaty, which provides for a 10% rate of withholding tax. Foreign-source interest received by the GBC is exempt from tax in Mauritius. </li></ul>II. Treaty Shopping U.S. Person SPV (e.g., GBC1) Limited Company United States Mauritius Uganda 15% Dividend and Interest Withholding Tax 10% Dividend and Interest Withholding Tax 0% Dividend and Interest Withholding Tax
  9. 9. <ul><li>Meaning of Treaty Shopping (cont’d) </li></ul><ul><li>Stepping stone conduits </li></ul><ul><li>The stepping stone conduit is an advanced conduit structure. In this case, payments received in State B are subject to tax in State A. However, State A tax is reduced by excessive interest, commission and other deductions that flow as income to a State C conduit, where they enjoy a special exemption regime. </li></ul>II. Treaty Shopping State C Conduit State A Company Limited Company State C State A State B Non-treaty Protected Payments Treaty-protected payments Deductible Payments e.g., commissions, interest, etc. that erode State A’s tax base Payments exempt in State C under a special tax regime Loans, mgt contracts, etc
  10. 10. <ul><li>Meaning of Treaty Shopping (cont’d) </li></ul><ul><li>Treaty shopping includes a situation where an individual who has both his permanent home and all his economic interests in State A, including a substantial shareholding in a State A company, and who, essentially in order to sell the shares and escape taxation in State A on the capital gains from the alienation (by virtue of paragraph 5 of Article 13), transfers his permanent home to State B, where such gains are subject to little or no tax. </li></ul>II. Treaty Shopping
  11. 11. <ul><li>Why Treaty Shopping is Undesirable </li></ul><ul><li>Treaty benefits negotiated between two or more states are extended to persons resident in a non-treaty (“third”) state in a way unintended by the contracting states. On the other hand, as there is no tax treaty between a third state and the contracting states, residents of the contracting states would not receive treaty-protected tax treatment with respect to income derived from the third state. Thus, the principle of reciprocity is breached. </li></ul><ul><li>Income may be exempted from taxation altogether or be subject to inadequate taxation in a way unintended by the contracting parties. This is especially true if the ultimate beneficial owner of the income is a resident of a country that follows the exemption system. “Double non-taxation” is inconsistent with the underlying assumption when negotiating treaties that income protected from source-country income tax will be taxed in the taxpayer’s country of residence or at least falls under the normal tax regime of that state. </li></ul><ul><li>The state of residence of the ultimate income beneficial owner has little incentive to enter into a treaty with the state of source, because residents of the state of residence can directly access treaty benefits from the state of source without the need for the state of residence to provide reciprocal benefits. </li></ul>II. Treaty Shopping
  12. 12. <ul><li>Anti-Treaty Shopping Measures in the U.S. Model Tax Convention </li></ul><ul><li>The United States has taken an aggressive approach to shut down treaty shopping techniques through a limitation on benefits (“LOB”) clause in its treaties and protocols. </li></ul><ul><li>The LOB clause is contained in Article 22 of the U.S. Model Tax Treaty. In general, the provision does not rely on a determination of purpose or intention but instead sets forth a series of objective tests. A resident of a Contracting State that satisfies one of the tests will receive benefits regardless of the motivations in choosing its particular business structure. </li></ul><ul><li>The LOB provision attempts to distinguish between treaty shopping arrangements (the target of the LOB clause) and bona fide transactions of enterprises operating internationally. </li></ul><ul><li>The LOB Clause uses three principal tests to determine eligibility for treaty benefits: </li></ul><ul><ul><li>Public company test; </li></ul></ul><ul><ul><li>Ownership / Base-erosion test; and </li></ul></ul><ul><ul><li>Active Business Test </li></ul></ul><ul><ul><li>Note that the tests are not concurrent tests. Only one test need be satisfied. </li></ul></ul>II. Treaty Shopping – The U.S. Approach
  13. 13. <ul><li>Benefit Eligibility Tests Applicable to Companies under the LOB Clause– </li></ul><ul><li>1. “Public Company” Test – Article 22(2)(c) </li></ul><ul><li>The public company test is based on the assumption that a publicly traded company has sufficient connection to the country in which its shares are listed. Where shares are not listed on a stock exchange of the country of residence, treaty benefits are not available unless the company’s primary place of management and control is located in the country of residence. </li></ul><ul><li>The public company test applies to publicly traded companies and subsidiaries of publicly traded companies. Under this test a company must satisfy the following criteria: </li></ul><ul><ul><li>the principal class of its shares, and any disproportionate class of shares, is regularly traded on one or more recognized stock exchanges , and </li></ul></ul><ul><ul><ul><li>the company’s principal class of shares is primarily traded on one or more recognized stock exchanges located in State R or, </li></ul></ul></ul><ul><ul><ul><li>the company’s primary place of management and control is in State R . residence. </li></ul></ul></ul>II. Treaty Shopping – The U.S. Approach
  14. 14. <ul><li>Benefit Eligibility Tests Applicable to Companies under the LOB Clause– </li></ul><ul><li>Public Company Test - Article 22(2)(c)(i) & (ii) (cont’d) </li></ul><ul><li>Under the subsidiary prong to the public company test, a company resident in State R is entitled to all the benefits of the Convention if 5 or fewer publicly traded companies that satisfy the public company test are the direct or indirect owners of at least 50 percent of the aggregate vote and value of the company’s shares (and at least 50 percent of any disproportionate class of shares). If the publicly-traded companies are indirect owners, however, each of the intermediate companies must be a resident of the United States or State R. </li></ul><ul><li>For example, XCo is a company resident in State R. All its shares are owned by YCo, also a resident of State R. XCo would qualify for benefits under the Convention if the principal class of shares (and any disproportionate classes of shares) of YCo are regularly and primarily traded on a recognized stock exchange in State R. However, XCo would not qualify for benefits under the ownership test if YCo were a resident of a third state, for example, and not a resident of the United States or State R. </li></ul><ul><li>A company whose principal class of shares is regularly traded on a recognized stock exchange will nevertheless not qualify for benefits under the public company test if it has a disproportionate class of shares that is not regularly traded on a recognized stock exchange. </li></ul>II. Treaty Shopping – The U.S. Approach
  15. 15. <ul><li>Benefit Eligibility Tests Applicable to Companies under the LOB Clause– </li></ul><ul><li>“ Public Company” Test – Article 22(2)(c) (cont’d) </li></ul><ul><li>“ Recognized stock exchange“ includes – </li></ul><ul><ul><li>The NASDAQ System and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purposes of the Securities Exchange Act of 1934; </li></ul></ul><ul><ul><li>Certain exchanges located in State R; and </li></ul></ul><ul><ul><li>Any other stock exchange agreed upon by the competent authorities of the Contracting States. </li></ul></ul><ul><li>“ Principal class of shares“ means the ordinary or common shares of the company representing the majority of the aggregate voting power and value of the company. </li></ul><ul><li>If the company does not have a class of ordinary or common shares representing the majority of the aggregate voting power and value of the company, then the &quot;principal class of shares&quot; is that class or any combination of classes of shares that represents, in the aggregate, a majority of the voting power and value of the company. </li></ul>II. Treaty Shopping – The U.S. Approach
  16. 16. <ul><li>Benefit Eligibility Tests Applicable to Companies under the LOB Clause– </li></ul><ul><li>“ Public Company” Test – Article 22(2)(c)(i) & (ii) – </li></ul><ul><li>A company has a disproportionate class of shares if it has outstanding a class of shares which is subject to terms or other arrangements that entitle the holder to a larger portion of the company’s income, profit, or gain in State R than that to which the holder would be entitled in the absence of such terms or arrangements. Example: Non-voting preferred stock that is owned by a single person, and which entitles the holder to an exclusive right to receive certain types of U.S. source income, would be considered a disproportionate class of shares (See Treasury Department Technical Explanation to the LOB Clause). </li></ul><ul><li>A company's &quot;primary place of management and control&quot; will be in State R if executive officers and senior management employees exercise day-to-day responsibility for more of the strategic, financial and operational policy decision making for the company (including its direct and indirect subsidiaries) in State R than in any other state AND the staff of such persons conduct more of the day-to-day activities necessary for preparing and making those decisions in State R than in any other state. </li></ul>II. Treaty Shopping – The U.S. Approach
  17. 17. <ul><li>Public Company Test (Art. 22(2)(c)(i) & (ii)) – </li></ul>II. Treaty Shopping – The U.S. Approach Is the Principal Class of its shares (and any disproportionate class of its shares regularly traded on one or more recognized stock exchanges? Is the Principal Class of its shares primarily traded on one or more recognized stock exchanges located in State R? Is the Company’s primary place of management and control located in State R? Eligible for Benefits Not Eligible for Benefits Yes Yes Yes No No No If 5 or fewer companies own ≥50% of the aggregate vote and value of shares (and ≥50% of any disproportionate class of shares) of the Subsidiary), do those companies satisfy criteria set forth in Art. 22(2)(c)(i)? Yes No Art. 22(2)(c)(ii) Art. 22(2)(c)(i)
  18. 18. <ul><li>Benefit Eligibility Tests Applicable to Companies under the LOB Clause– </li></ul><ul><li>2. Ownership/Base Erosion Test – Article 22(2)(e). </li></ul><ul><li>The ownership/base erosion test attempts to ensure that if a State R company enjoys benefits as a resident of State R, the ultimate beneficiaries of treaty relief are residents of State R, not residents of third states. </li></ul><ul><li>The ownership and base erosion test is a two-part test. Both prongs of the test must be satisfied for the resident to be entitled to treaty benefits under this test. </li></ul><ul><li>The ownership prong of the test requires that 50 percent or more of each class of shares or other beneficial interests in the State R enterprise is owned, directly or indirectly, on at least half the days of the taxable year of the State R enterprise by persons who are residents of State R and that are themselves entitled to treaty benefits under one of the tests for benefits eligibility. In the case of indirect owners, however, each of the intermediate owners must be a resident of State R. </li></ul><ul><li>The base erosion prong is not satisfied if 50 percent or more of the gross income of a State R enterprise for the taxable year, as determined under the tax law of State R, is paid or accrued to persons who are not residents of State R and/or the United States entitled to benefits under one of the tests for benefit eligibility, in the form of payments deductible for tax purposes in State R. </li></ul>II. Treaty Shopping – The U.S. Approach
  19. 19. <ul><li>Benefit Eligibility Tests Applicable to Companies under the LOB Clause – </li></ul>II. Treaty Shopping – The U.S. Approach Is ≥50% of the aggregate vote and value of shares (and ≥50% of any disproportionate class of shares) of the Company beneficially owned (directly or indirectly) by qualified persons under Art. 22(2)(a), (b), (c)(i) or (d) for at least half the days of the taxable year? Has <50% of the Company’s gross income for the taxable year, as determined under the tax laws of the State of Residence (“R”), been paid or accrued directly or indirectly to persons not entitled to benefits under Art. 22(2)(a), (b), (c)(i) or (d)? Eligible for Benefits Not Eligible for Benefits Yes No Yes No 2. Ownership and Base Erosion Test - Art. 22(2)(e) (cont’d)
  20. 20. <ul><li>Benefit Eligibility Tests Applicable to Companies under the LOB Clause– </li></ul><ul><li>3. Trade or Business Test - Article 22(3). </li></ul><ul><li>In general, a resident of State R engaged in the active conduct of a trade or business in State R may obtain the benefits of the Convention with respect to an item of income derived in the United States. The item of income, however, must be derived in connection with or incidental to the trade or business in State R. </li></ul><ul><li>A trade or business will be considered to be a specific unified group of activities that constitute or could constitute an independent economic enterprise carried on for profit. A corporation generally will be considered to carry on a trade or business only if the officers and employees of the corporation conduct substantial managerial and operational activities. </li></ul><ul><li>The business of making or managing investments for the resident’s own account will be considered to be a trade or business only when part of banking, insurance or securities activities conducted by a bank, an insurance company, or a registered securities dealer. Such activities conducted by a person other than a bank, insurance company or registered securities dealer will not be considered to be the conduct of an active trade or business, nor would they be considered to be the conduct of an active trade or business if conducted by a bank, insurance company or registered securities dealer but not as part of the company’s banking, insurance or dealer business. </li></ul>II. Treaty Shopping – The U.S. Approach
  21. 21. <ul><li>Benefit Eligibility Tests Applicable to Companies under the LOB Clause– </li></ul><ul><li>3. Trade or Business Test - Article 22(3). </li></ul><ul><li>Under Art. 22(3)(b), if a person’s associated enterprise is engaged in the active conduct of a trade or business in State R, that person may obtain the benefits of the Convention with respect to an item of income derived in the United States provided the business activity conducted in State R is substantial. </li></ul><ul><li>The substantiality requirement is intended to prevent a narrow case of treaty-shopping abuses in which a company attempts to qualify for benefits by engaging in de minimis connected business activities in the treaty country in which it is resident ( i.e. , activities that have little economic cost or effect with respect to the company business as a whole). </li></ul><ul><li>The determination of substantiality is made based upon all the facts and circumstances and takes into account the comparative sizes of the trades or businesses in each Contracting State, the nature of the activities performed in each Contracting State, and the relative contributions made to that trade or business in each Contracting State. In any case, in making each determination or comparison, due regard will be given to the relative sizes of the economies in the two Contracting States. </li></ul>II. Treaty Shopping – The U.S. Approach
  22. 22. <ul><li>3. Active Business Test (Art. 22(3)(a)&(b)). </li></ul>II. Treaty Shopping – The U.S. Approach Is the Company or its Associated Enterprise engaged in the active conduct of a trade or business in State R? Is the above business a business of making or managing investments on own account? Eligible for Benefits Not Eligible for Benefits Is the income from U.S. sources derived in connection with or incidental to the trade or business conducted in State R? Is the State R enterprise a Bank, Insurance Company or Registered Securities Dealer? Is the business activity conducted in State R substantial? No Yes No Yes No Yes No Yes No Yes
  23. 23. <ul><li>Benefit Eligibility Tests Applicable to Individuals, Pension Funds, Charities and Like Institutions under the LOB Clause - </li></ul><ul><li>Individual residents of State R are entitled to all treaty benefits. </li></ul><ul><li>If an individual receives income as a nominee on behalf of a third country resident, benefits may be denied under the respective articles of the Convention by the requirement that the beneficial owner of the income be a resident of State R. </li></ul><ul><li>A pension fund will qualify for benefits if more than 50 percent of the beneficiaries, members or participants of the organization are individuals resident in State R and/or the United States. </li></ul><ul><li>For purposes of this provision, the term &quot;beneficiaries&quot; should be understood to refer to the persons receiving benefits from the organization. </li></ul><ul><li>A tax-exempt organization other than a pension fund automatically qualifies for benefits, without regard to the residence of its beneficiaries or members. Entities qualifying under this rule generally are those that are exempt from tax in State R and that are organized and operated exclusively to fulfill religious, charitable, scientific, artistic, cultural, or educational purposes. </li></ul>II. Treaty Shopping – The U.S. Approach
  24. 24. <ul><li>Benefit Eligibility Tests Applicable to Individuals, Pension Funds, Charities and Like Institutions under the LOB Clause - </li></ul>II. Treaty Shopping – The U.S. Approach Individuals Charities, Religious Organizations, etc. No Pension Funds Do individuals resident in State R and the United States collectively own more than 50 percent of the pension, fund? Is the individual resident in State R for purposes of Article 4 of the Convention? Eligible for Benefits Not Eligible for Benefits No Yes Yes Article 22(2)(a) Article 22(2)(d), Article 4(2) Yes
  25. 25. <ul><li>Conduit Company Cases </li></ul><ul><li>A report of the OECD Committee on Fiscal Affairs, entitled “Double Taxation Conventions and the Use of Conduit Companies”, recommends a number of approaches to counter the treaty shopping problem. </li></ul><ul><li>1. “Look-through” Approach </li></ul><ul><li>Under the look-through approach, a company that is a resident of State R would be denied treaty benefits with respect to items of income and gains if it is owned or controlled directly or through one or more companies wherever resident, by persons who are not residents of State R. </li></ul><ul><li>The look-through approach would ensure that the ultimate beneficiaries of treaty relief are residents of State R, not residents of third states. </li></ul><ul><li>This approach is too broad. It does not distinguish between abusive transactions and bona fide business transactions. </li></ul>II. Treaty Shopping – The OECD Approach
  26. 26. <ul><li>Conduit Company Cases (cont’d) </li></ul><ul><li>2. The “Subject-to-tax” Approach </li></ul><ul><li>Under the subject-to-tax approach, a company that is a resident of State R would be granted treaty benefits in State S only if the income in question is subject to tax in State R under the ordinary rules of its tax law. This approach does not offer adequate protection against advanced tax-avoidance strategies such as ‘stepping-stone strategies’. </li></ul><ul><li>3. The “Channel” Approach </li></ul><ul><li>The OECD Committee on Fiscal Affairs has recommended a provision similar to the U.S. ownership/base erosion test, drafted in the following terms: </li></ul><ul><li>“ Where income arising in State S is received by a company that is a resident of State R, and one or more persons who are not residents of State R </li></ul><ul><li>have directly or indirectly, …a substantial interest in such company, in the form of a participation or otherwise, or </li></ul><ul><li>exercise directly or indirectly, alone or together, the management or control of such company </li></ul><ul><li>any provision of this Convention conferring an exemption from, or a reduction of, tax shall not apply if more than 50% of such income is used to satisfy claims by such persons (including interest, royalties, development, advertising, initial travel expenses, and depreciation of any kind of business assets including those in immaterial goods and process”. </li></ul>II. Treaty Shopping – The OECD Approach
  27. 27. <ul><li>Conduit Company Cases (cont’d) </li></ul><ul><li>To ensure that bona fide business transactions are not subject to the proposed anti-treaty shopping provision, the OECD Committee on Fiscal Affairs has proposed the following exceptions: </li></ul><ul><ul><li>Where the treaty benefit claimant establishes that its conduct of business and the acquisition or maintenance of its shareholding or other property, are motivated by sound business reasons and do not have as primary purpose the obtaining of benefits under the convention. </li></ul></ul><ul><ul><li>Conduct of substantial business operations in State R and the income with respect to which treaty benefits are claimed is connected with such operations. </li></ul></ul><ul><ul><li>The tax actually imposed by State R is greater than the reduction of tax claimed in State S. </li></ul></ul><ul><ul><li>A company resident in State R that has the principal class of its shares registered on approved stock exchange in a contracting state, or if such company is wholly-owned directly or through one or more companies, each of which is a resident of a contracting state, and the principal class of whose shares is so registered. </li></ul></ul><ul><ul><li>Residents of third states have income tax conventions in force with State S and such conventions provide relief from taxation not less than the relief from taxation under the convention in question. </li></ul></ul>II. Treaty Shopping – The OECD Approach
  28. 28. <ul><li>Conduit Company Cases (cont’d) </li></ul><ul><li>4. The “Exclusion” Approach </li></ul><ul><li>Certain types of companies enjoying tax privileges in State R facilitate conduit arrangements and raise the issue of harmful tax practices (e.g., the Mauritian GBC1). The OECD Committee on Fiscal Affairs recommends three alternative ways to tackle the problem of tax privileged companies – </li></ul><ul><ul><li>Deny the tax benefits to such companies by excluding them from the scope of the tax convention; </li></ul></ul><ul><ul><li>Insert a safeguarding clause which would apply to the income received or paid by such companies. Under this approach, tax privileged companies would remain entitled to treaty benefits but only certain types of income, such as dividends, interest, capital gains or director’s fees, are excluded; or </li></ul></ul><ul><ul><li>Deny treaty benefits to a foreign-held company that enjoys a preferential tax regime in State R, where similarly situated company held by residents of State R would not enjoy preferential tax treatment in State R. </li></ul></ul>II. Treaty Shopping – The OECD Approach
  29. 29. <ul><li>1. Beneficial Ownership Requirement </li></ul><ul><ul><li>Both the U.S. and OECD Model Tax Conventions contain a beneficial ownership requirement in Articles 10, 11 and 12. Under this requirement, a state is not obligated to give up its taxing rights over dividends, interests or royalties merely because the income was immediately received by a resident State R. </li></ul></ul><ul><ul><li>The term “beneficial owner” is not used in a narrow technical sense, rather, it should be understood in its context and in light of the object and purpose of the convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance. </li></ul></ul><ul><ul><li>In practice, beneficial ownership is determined with the assistance of domestic “anti-abuse” provisions such as business purpose doctrine, the step-transaction and substance-over-form doctrines and conduit principles. Although each case is limited to a particular set of facts, there are a number of common factors which are generally considered by the courts as part of a beneficial ownership analysis: </li></ul></ul><ul><ul><li>Title/Possession – whether a taxpayer possesses legal title or has physical possession of the underlying asset. </li></ul></ul><ul><ul><li>Capitalization – whether the entity holding the asset is adequately capitalized. </li></ul></ul><ul><ul><li>Economic Risk – whether a taxpayer is exposed to the economic risks associated with a particular asset. </li></ul></ul>II. Treaty Shopping – Shared Approaches
  30. 30. <ul><li>1. Beneficial Ownership Requirement (cont’d) </li></ul><ul><ul><li>Profits – whether a taxpayer is entitled to the profits or income related to a particular asset. </li></ul></ul><ul><ul><li>Liability – whether a taxpayer assumes the liabilities associated with a particular asset (e.g., payment of taxes). </li></ul></ul><ul><ul><li>Dominion and Control – whether a taxpayer has the power to make decisions related to the asset, such as the decision to dispose of the asset. </li></ul></ul><ul><ul><li>Agency Relationship – whether the nature of the relationship between the taxpayer and the party in possession (legal or physical) of a particular asset created an agency relationship. </li></ul></ul><ul><ul><li>Treaty benefits will be denied if State S successfully asserts that the conduit company established in a treaty jurisdiction lacks beneficial ownership of the income that is sought to be protected by the relevant treaty provisions. </li></ul></ul>II. Treaty Shopping – Shared Approaches
  31. 31. <ul><li>1. Beneficial Ownership Requirement (cont’d) </li></ul>II. Treaty Shopping – Shared Approaches SPV “ Issuer” Parent Guarantor Noteholders Mauritius Indonesia loan loan Interest subject to DTA WHT of 10% Interest not subject to tax Indofood International Finance Ltd v JPMorgan Chase Bank, N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal. Facts PT Indofood SM (&quot;the Parent Guarantor&quot;) , a company incorporated in the Republic of Indonesia, carried on substantial business in the production and distribution of food. It wished to raise capital by issue of loan notes on the international market. If it had done so itself, it would have been obliged under Indonesian law to deduct 20% as withholding tax on interest payable to the noteholders. The rate of withholding tax could be reduced to 10% if the issue of the loan notes was made by a wholly owned subsidiary incorporated in Mauritius and the capital so raised was lent on to the Parent Guarantor on terms which complied with the conditions specified in the Indonesia - Mauritius tax treaty. Accordingly, the Parent Guarantor procured the incorporation in Mauritius of the claimant Indofood International Finance Limited (&quot;the Issuer&quot;). The Issuer raised US$280m loan notes and lent the capital so raised to the Parent Guarantor on the same terms. The issue, servicing and redemption of the loan notes and the loan to the Parent Guarantor were regulated, inter alia, by a Trust Deed under which JPMorgan Chase (&quot;the Trustee&quot;) was appointed trustee for the noteholders.
  32. 32. <ul><li>1. Beneficial Ownership Requirement (cont’d) </li></ul>II. Treaty Shopping – Shared Approaches SPV “ Issuer” SPV NewCo Noteholders Mauritius Netherlands loan Assignment of Issuer Rights Onward payment of interest paid by Parent Guarantor Interest not subject to tax Parent Guarantor Indonesia Interest subject to DTA WHT of 10% Indofood International Finance Ltd v JPMorgan Chase Bank, N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal (Civil Division) Facts (cont’d) Under terms of the notes, if there was a change in Indonesian law whereby the obligation to withhold tax from interest payable to the Issuer exceeded the rate of 10% for which the Mauritian DTA provided, and &quot;such obligation cannot be avoided by the Issuer taking reasonable measures available to it&quot; , the Issuer might, with the approval of the Trustee, redeem the notes. In 2004, Indonesia issued a notice to terminate the Mauritius DTA effective January 1, 2005, the effect of which would be that the Parent Guarantor would be obligated to withhold at the rate of 20%. Accordingly, the Issuer gave notice to the Trustee of its intention to redeem the loan notes. The Trustee refused approval of the redemption on the grounds that the Issuer had reasonable measures available to reduce the increased liability for withholding tax (i.e., that the Issuer assign the benefit of the loan agreement between the Issuer and Parent Guarantor to a company incorporated in Netherlands (&quot;NewCo&quot;), which, the Trustee argued, would have reduced the rate of withholding tax to 10% under the Indonesia - Netherlands treaty).
  33. 33. <ul><li>1. Beneficial Ownership Requirement (cont’d) </li></ul>II. Treaty Shopping – Shared Approaches SPV “ Issuer” SPV NewCo Noteholders Mauritius Netherlands loan Assignment of Issuer Rights Onward payment of interest paid by Parent Guarantor Interest not subject to tax Parent Guarantor Indonesia Interest subject to DTA WHT of 10% Indofood International Finance Ltd v JPMorgan Chase Bank, N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal (Civil Division) Issue Whether the interposition of NewCo between the Parent Guarantor and the Issuer could reduce the rate of withholding tax in respect of interest payable by the Parent Guarantor under the loan agreement to 10% or less - which depended, inter alia, on whether NewCo could be the beneficial owner of the interest payable by the Parent Guarantor. Holding / Observations on Beneficial Ownership A conduit can normally not be regarded as the beneficial owner if, though the formal owner of certain assets, it has very narrow powers which render it a mere fiduciary or an administrator acting on account of the interested parties (most likely the shareholders of the conduit company). One way to test beneficial ownership is to ask: what would happen if the recipient went bankrupt before paying over the income to the intended, ultimate recipient?
  34. 34. <ul><li>1. Beneficial Ownership Requirement (cont’d) </li></ul>II. Treaty Shopping – Shared Approaches SPV “ Issuer” SPV NewCo Noteholders Mauritius Netherlands loan Assignment of Issuer Rights Onward payment of interest paid by Parent Guarantor Interest not subject to tax Parent Guarantor Indonesia Interest subject to DTA WHT of 10% Indofood International Finance Ltd v JPMorgan Chase Bank, N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal (Civil Division) Observations on Beneficial Ownership (cont’d) If the ultimate recipient could claim the funds as its own, then the funds are properly regarded as already belonging to the ultimate recipient. If, however, the ultimate recipient would simply be one of the creditors of the actual recipient, then the funds properly belong to the actual recipient. The meaning to be given to the phrase 'beneficial owner' is plainly not to be limited by so technical and legal an approach. Regard is to be had to the substance of the matter. In accordance with the legal structure, Parent Guarantor is obligated to pay interest two business days before the due date to the credit of an account nominated for the purpose of the Issuer and the Issuer is obliged to pay the interest due in one business day before the due date to the account specified by the Principal Paying Agent. In both commercial and practical terms, the Issuer is, and NewCo would be, bound [by the Note Conditions] to pay on to the Principal Paying Agent that which it receives from the Parent Guarantor. In practical terms, the Issuer or NewCo lacked the 'full privilege’ needed to qualify as the beneficial owner, rather the position of the Issuer and NewCo equates to that of an 'administrator of the income‘.
  35. 35. <ul><li>2. Place of Effective Management of Subsidiary Companies </li></ul><ul><ul><li>Claims to treaty benefits by subsidiary companies established in tax havens or benefiting from harmful preferential regimes may be refused where the facts and circumstances suggest that the place of effective management of a subsidiary does not lie in its alleged state of residence, but rather lies in the state of residence of the parent company. </li></ul></ul><ul><ul><li>The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity's business as a whole are in substance made . All relevant facts and circumstances must be examined to determine the place of effective management. An entity may have more than one place of management, but it can have only one place of effective management at any one time. </li></ul></ul><ul><ul><li>Careful consideration of the facts and circumstances may also show that a subsidiary was managed and controlled in the state of residence of the parent company in such a way that the subsidiary had a permanent establishment (e.g., by having a place of management) in that state to which all or a substantial part of its profits were properly attributable. </li></ul></ul>II. Treaty Shopping – Shared Approaches
  36. 36. <ul><li>Key Differences Between the OECD & U.S. Approaches </li></ul><ul><li>In significant part, the approaches taken by the U.S. and OECD against treaty shopping are substantially similar. However, the following differences are notable: </li></ul><ul><li>Some of the recommended OECD approaches look at the subjective intent of the taxpayer in the conduct of business or acquisition of property. On the other hand, the U.S. approach relies on predetermined objective criteria. The subjective intent of the taxpayer is a facts-and-circumstances inquiry. </li></ul><ul><li>Some of the recommended OECD approaches are too generalized (e.g., the exclusion approach). On the other hand, the U.S. LOB clause is specifically targeted. Leonard Beighton, a former Deputy Chairman of the U.K. Board of Internal Revenue, is quoted as having noted that the U.K. does not favor general anti-treaty shopping provisions for the reason that they are likely to hit the wrong targets and create uncertainty; that the significant degree of discretion they give to officials is undesirable; that they are likely to be costly and difficult to operate; and that in practice such widely targeted provisions may not prevent abuse ( See “Treaty Shopping: Imitation is Flattering” - [2000] BTR 133 ). </li></ul><ul><li>Most of the anti-treaty shopping approaches recommended by the OECD Committee on Fiscal Affairs have not been officially incorporated into the model tax convention. On the other hand, the U.S. has incorporated the LOB clause in its model tax convention and every treaty negotiated after 1989. </li></ul>II. Treaty Shopping – Conclusions
  37. 37. <ul><li>Treasury Department Technical Explanations to the U.S. Model Tax Convention (November 15, 2006). </li></ul><ul><li>Report of the OECD on Fiscal Affairs – “Double Taxation Conventions and the Use of Conduit Companies” (2005). </li></ul><ul><li>Commentary of the OECD Committee on Fiscal Affairs to Articles 1, 10-12 of the OECD Model Tax Convention (July 17, 2008). </li></ul><ul><li>Daniel M. Berman and John L. Hynes: “Limitation on Benefits Clauses in U.S. Income Tax Treaties. </li></ul><ul><li>Craig Elliffe: “The Interpretation and Meaning of ‘Beneficial’ Owner in New Zealand” – B.T.R. 2009, 3, 276-305 </li></ul><ul><li>Rose Fraser & J.D.B. Oliver: “Treaty Shopping and Beneficial Ownership: Indofood International Finance Limited v JP Morgan Chase NA London Branch” – B.T.R. 2006, 4, 422-429. </li></ul>II. Treaty Shopping – Recommended Readings
  38. 38. <ul><li>Thank You </li></ul>

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