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Treaty Platforms: Traps For The Unwary
 

Treaty Platforms: Traps For The Unwary

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The presentation features Ugandan and OECD approaches to the use of tax treaty platforms.

The presentation features Ugandan and OECD approaches to the use of tax treaty platforms.

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    Treaty Platforms: Traps For The Unwary Treaty Platforms: Traps For The Unwary Presentation Transcript

    • TAX TREATY PLATFORMS Traps for the Unwary Presented By: Festus Akunobera, Esq. LL.M., International Tax (NYU); LL.B., 1st Class (MUK); Dip LP (LDC) Attorney & Counselor at Law (New York, USA); Advocate (Uganda) CEO, East African School of Taxation Partner, Akunobera & Akena, Tax & Legal Consultants Tel. +256 (782) 405-913 Email: akunobera@taxation.east.co.ug March 24, 2010 Centre for Continuing Education, East African School of Taxation
    • TABLE OF CONTENTS I. BACKGROUND II. TREATY SHOPPING III. ANTI-TREATY SHOPPING MEASURES 2
    • I. BACKGROUND
    • I. Background Reasons for Concluding Tax Treaties 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). Illustration 1(a): Tata, an Indian multinational corporation, is engaged in manufacturing in Uganda. Tata derives income from its manufacturing operations in Uganda. • India imposes income tax on its residents‟ worldwide income. Uganda imposes tax on income derived by foreign corporations from sources in Uganda. • If there were no tax treaty between India and Uganda, Tata would incur Ugandan tax on income derived from its manufacturing operations in Uganda (i.e., Ugandan sourced-based tax) and incur Indian residence-based tax on income derived from its operations in Uganda. 4
    • I. Background Reasons for Concluding Tax Treaties (cont’d) Illustration 1(b): Tata, an Indian multinational corporation, is engaged in manufacturing in Uganda. Automobiles manufactured in Uganda are sold in South Africa. • Assume that income derived from goods manufactured in Uganda is treated as derived from sources in Uganda. Assume also that income derived from sales of goods in South Africa is treated as derived from sources in South Africa. • Tata is at risk of incurring Ugandan source-based tax, South African source based tax and Indian residence-based tax. • Would a treaty between Uganda and South Africa alleviate the double taxation problem as between South Africa and Uganda? – No. treaty benefits are available only to residents of contracting states, and in our illustration, Tata is resident in neither Uganda nor South Africa. 5
    • I. Background Reasons for Concluding Tax Treaties (cont’d) There are two principal means adopted under tax treaties to alleviate the double taxation problem: • 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. • 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. Note: Most countries unilaterally grant an exemption or foreign tax credit under domestic law. 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). 6
    • I. Background Reasons for Concluding Tax Treaties (cont’d) 2. Prevention of Tax Avoidance and Evasion (See Para. 7 of the OECD Commentary to Article 1 of the OECD Model Convention). • 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. • 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. 7
    • I. Background Uganda’s Tax Treaty Network • Currently, Uganda has 9 tax treaties in force: Denmark (2001), India (2004), Italy (2005), Mauritius (2004), Netherlands (2006), Norway (2001), South Africa (2001), United Kingdom (1993) and Zambia (1968). • The Uganda – Belgium DTT was signed in 2007 but it is not yet in force. The tripartite Income Tax Agreement between Uganda, Kenya and Tanzania was signed in 1997 but it is not yet in force. Status of a Tax Treaty under Domestic Tax Law • S. 88(1) of the Act provides that an international agreement entered into between the Government of Uganda and the government of a foreign country or foreign countries shall effect as if the agreement was contained in the Act. • S. 88(6) of the Act defines „international agreement‟ as – – An agreement with a foreign government for the relief of international double taxation and the prevention of fiscal evasion; or – An agreement with a foreign government providing for reciprocal administrative assistance in the enforcement of tax liabilities. • Note: The definition of international agreement is exhaustive. Therefore, an agreement of the kind not defined in S. 88(6) is not an international agreement within the meaning of the Act (e.g., a technical assistance is not an international agreement for income tax purposes). 8
    • I. Background Status of a Tax Treaty under Domestic Tax Law (cont’d) • An international agreement takes precedence over the provisions of the Act in the event of conflict. However, the tax avoidance provisions of the Act (i.e., S. 90 – transactions between associates and S. 91 - tax avoidance schemes) take precedence over the tax treaty (S. 88(2) of the Act). 9
    • II. TREATY SHOPPING
    • II. Treaty Shopping Meaning of Treaty Shopping • 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. • Treaty shopping is commonly accomplished through what are known as „conduit‟ entities or special purpose vehicles. • 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. • The conduit company is usually able to enjoy reduced withholding tax rates or exemption from capital gains tax in the source country. 11
    • II. Treaty Shopping Meaning of Treaty Shopping (cont’d) Direct Conduit Structure In the illustration below, instead of a United States person investing directly in a Ugandan company and incurring 15% withholding tax, the United States person invests through a Mauritius GBC structure. As such, the United States 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. United States Person 0% Dividend and United States Interest Withholding Tax 15% Dividend and SPV (e.g., GBC1) Interest Withholding Tax 10% Dividend and Mauritius Interest Withholding Tax Limited Company Uganda 12
    • II. Treaty Shopping Meaning of Treaty Shopping (cont’d) Stepping stone conduits 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. State C Conduit Payments exempt in State C under a special tax regime Loans, mgt contracts, etc State C Deductible Payments e.g., Non-treaty Protected commissions, interest, etc. State A Company Payments that erode State A‟s tax base State A Treaty-protected payments Limited Company State B 13
    • II. Treaty Shopping Meaning of Treaty Shopping (cont’d) • 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. 14
    • II. Treaty Shopping Why Treaty Shopping is Undesirable • 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. • 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. • 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. 15
    • III. ANTI-TREATY SHOPPING MEASURES
    • III. Anti- Treaty Shopping: Statutory Measures ‘Ownership’ Test under S. 88(5) of the Income Tax Act  A treaty benefit (i.e., exemption from, or reduction of, Ugandan tax) is not available to any person who, for the purposes of the agreement, is a resident of the other country state where 50% or more of the underlying ownership of that person is held by an individual or individuals who are not residents of that other contracting state for purposes of the agreement. Analysis Framework under S. 88(5) Is ≥50% of the underlying ownership of a State R enterprise held by an individual or individuals? No Yes Do the individuals that hold ≥50% Yes of the underlying ownership of a State R enterprise reside in State R for purposes of the International Agreement? No Eligible for Benefits Not Eligible for Benefits • S. 88(5) uses the phrase „underlying ownership‟ as opposed to the term „ownership‟. The phrase „underlying ownership‟ permits an inquiry into the ultimate owners of the enterprise, not merely its immediate owners. 17
    • III. Anti- Treaty Shopping: Statutory Measures General Anti-Avoidance Provisions • S. 88(2) cross-references Ss. 90 and 91 of the Act, as a backstop against treaty-based tax avoidance schemes. S. 90 is a transfer pricing provision, while S. 91 is a general anti- avoidance provision. • S. 91 permits the commissioner to recast/ recharacterise a transaction or an element of a transaction where – ‾ It was entered into as part of a tax avoidance scheme; ‾ It does not have substantial economic effect; or ‾ The form of the transaction does not reflect the substance • S. 91(2) defines „tax avoidance scheme‟ to include a transaction, one of the main purposes of which is the avoidance or reduction of liability to tax. 18
    • III. Anti- Treaty Shopping: Treaty-based Measures Conduit Company Cases  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. 1. “Look-through” Approach • 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. • The look-through approach would ensure that the ultimate beneficiaries of treaty relief are residents of State R, not residents of third states. • This approach is too broad. It does not distinguish between abusive transactions and bona fide business transactions. 19
    • III. Anti- Treaty Shopping: Treaty-based Measures Conduit Company Cases (cont’d) 2. The “Subject-to-tax” Approach • 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‟. 3. The “Channel” Approach • The OECD Committee on Fiscal Affairs has recommended a provision similar to the Ugandan ownership/base erosion test, drafted in the following terms: “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 a) have directly or indirectly, …a substantial interest in such company, in the form of a participation or otherwise, or b) exercise directly or indirectly, alone or together, the management or control of such company 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”. 20
    • III. Anti- Treaty Shopping: Treaty-based Measures Conduit Company Cases (cont’d) • 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: – 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. – Conduct of substantial business operations in State R and the income with respect to which treaty benefits are claimed is connected with such operations. – The tax actually imposed by State R is greater than the reduction of tax claimed in State S. – 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. – 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. 21
    • III. Anti- Treaty Shopping: Treaty-based Measures Conduit Company Cases (cont’d) 4. The “Exclusion” Approach • 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 – – Deny the tax benefits to such companies by excluding them from the scope of the tax convention; – 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 – 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. 22
    • III. Anti- Treaty Shopping: Treaty-based Measures 5. Beneficial Ownership Requirement • The OECD Model Tax Convention and all the tax treaties Uganda has concluded contain a beneficial ownership requirement in Articles 10, 11 and 12 (these provisions are based on the OECD Model Tax Convention). 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. • 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. • 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 in the commonwealth as part of a beneficial ownership analysis: - Title/Possession – whether a taxpayer possesses legal title or has physical possession of the underlying asset. - Capitalization – whether the entity holding the asset is adequately capitalized. - Economic Risk – whether a taxpayer is exposed to the economic risks associated with a particular asset. 23
    • III. Anti- Treaty Shopping: Treaty-based Measures 5. Beneficial Ownership Requirement (cont’d) - Profits – whether a taxpayer is entitled to the profits or income related to a particular asset. - Liability – whether a taxpayer assumes the liabilities associated with a particular asset (e.g., payment of taxes). - 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. - 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.  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. 24
    • III. Anti- Treaty Shopping: Treaty-based Measures 5. Beneficial Ownership Requirement (cont’d) Indofood International Finance Ltd v JPMorgan Chase Bank, N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal. Facts PT Indofood SM ("the Parent Guarantor") , a company incorporated Parent in the Republic of Indonesia, carried on substantial business in the Guarantor production and distribution of food. It wished to raise capital by issue Interest subject to Indonesia of loan notes on the international market. If it had done so itself, it DTA WHT of 10% would have been obliged under Indonesian law to deduct 20% as loan 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 SPV and the capital so raised was lent on to the Parent Guarantor on terms “Issuer” which complied with the conditions specified in the Indonesia - Interest not Mauritius tax treaty. Accordingly, the Parent Guarantor procured the Mauritius subject to tax incorporation in Mauritius of the claimant Indofood International loan Finance Limited ("the Issuer"). 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 Noteholders redemption of the loan notes and the loan to the Parent Guarantor were regulated, inter alia, by a Trust Deed under which JPMorgan Chase ("the Trustee") was appointed trustee for the noteholders. 25
    • III. Anti- Treaty Shopping: Treaty-based Measures 5. Beneficial Ownership Requirement (cont’d) Indofood International Finance Ltd v JPMorgan Chase Bank, N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal Parent (Civil Division) Guarantor Interest subject to Facts (cont’d) DTA WHT of 10% Indonesia 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 SPV provided, and "such obligation cannot be avoided by the Issuer NewCo taking reasonable measures available to it", the Issuer might, with Onward payment of interest paid by Netherlands the approval of the Trustee, redeem the notes. Parent Guarantor Assignment of In 2004, Indonesia issued a notice to terminate the Mauritius DTA Issuer Rights effective January 1, 2005, the effect of which would be that the Parent Guarantor would be obligated to withhold at the rate of SPV 20%. Accordingly, the Issuer gave notice to the Trustee of its “Issuer” intention to redeem the loan notes. The Trustee refused approval of Interest not the redemption on the grounds that the Issuer had reasonable subject to tax Mauritius measures available to reduce the increased liability for withholding loan 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 ("NewCo"), which, the Trustee argued, would have reduced the rate of withholding tax to 10% under the Noteholders Indonesia - Netherlands treaty). 26
    • III. Anti- Treaty Shopping: Treaty-based Measures 5. Beneficial Ownership Requirement (cont’d) Indofood International Finance Ltd v JPMorgan Chase Bank, N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal Parent (Civil Division) Guarantor Interest subject to Issue DTA WHT of 10% Indonesia 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 SPV to 10% or less - which depended, inter alia, on whether NewCo NewCo could be the beneficial owner of the interest payable by the Parent Onward payment of interest paid by Netherlands Guarantor. Parent Guarantor Assignment of Holding / Observations on Beneficial Ownership Issuer Rights A conduit can normally not be regarded as the beneficial owner if, SPV though the formal owner of certain assets, it has very narrow “Issuer” powers which render it a mere fiduciary or an administrator acting Interest not on account of the interested parties (most likely the shareholders of subject to tax Mauritius the conduit company). loan 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? Noteholders 27
    • III. Anti- Treaty Shopping: Treaty-based Measures 5. Beneficial Ownership Requirement (cont’d) Indofood International Finance Ltd v JPMorgan Chase Bank, N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal (Civil Division) Parent Guarantor Observations on Beneficial Ownership (cont’d) Interest subject to If the ultimate recipient could claim the funds as its own, then the DTA WHT of 10% Indonesia 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 SPV belong to the actual recipient. NewCo Onward payment of The meaning to be given to the phrase 'beneficial owner' is plainly interest paid by Netherlands not to be limited by so technical and legal an approach. Regard is Parent Guarantor to be had to the substance of the matter. In accordance with the Assignment of legal structure, Parent Guarantor is obligated to pay interest two Issuer Rights 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 SPV pay the interest due in one business day before the due date to the “Issuer” account specified by the Principal Paying Agent. In both Interest not Mauritius commercial and practical terms, the Issuer is, and NewCo would subject to tax be, bound [by the Note Conditions] to pay on to the Principal loan 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 Noteholders income„. 28
    • III. Anti- Treaty Shopping: Treaty-based Measures 6. Place of Effective Management of Subsidiary Companies • 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. • 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. • 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. 29
    • III. Anti- Treaty Shopping: Treaty-based Measures Note  Some of the recommended OECD approaches are too generalized (e.g., the exclusion approach). 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).  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. 30
    • III. Anti- Treaty Shopping Measures – Recommended Readings 1. Report of the OECD on Fiscal Affairs – “Double Taxation Conventions and the Use of Conduit Companies” (2005). 2. Commentary of the OECD Committee on Fiscal Affairs to Articles 1, 10-12 of the OECD Model Tax Convention (July 17, 2008). 3. Craig Elliffe: “The Interpretation and Meaning of „Beneficial‟ Owner in New Zealand” – B.T.R. 2009, 3, 276-305 4. 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. 31
    • Thank you