6.3.3 The residence definition

The concept of treaty residence is key when it comes to treaty shopping. It provides opportunities for tax avoidance for groups of companies because group members are taxed separately.1 Between those separately taxed companies income flows can be structured in the most beneficial way, as each entity is in principle seen as a tax treaty resident. Truly combatting those treaty shopping opportunities would require treating the multinational group as one single entity for tax purposes, rather than introducing another clause to combat abuse. In the absence of such an overarching solution, the question is whether the residence definition can be amended to be better suitable to eliminate tax avoidance possibilities for companies in a group.

To determine whether an entity is a treaty resident generally a formal legal approach is applied, which lacks economic rationale. In other words, the rules to determine whether or not a corporation is present in a country from a tax point of view are currently too narrow.2 Though, an advantage of the legal approach is that it leads to legal certainty. However, to determine whether an entity is a treaty resident, looking at the conducted activities seems more in line with the objectives of the OECD MTC and would eliminate tax avoidance opportunities. This requires determining whether there is an economic or commercial connection.3 Solely taking into account the place of effective management is not sufficient, as this can easily be manipulated via, e.g., ‘fly-in, fly-out management’.4

Wheeler suggests to introduce the requirement that there is a sufficient connection between the person on whom the tax liability is imposed and the state from which treaty protection is claimed, before treaty benefits can be successfully claimed.5 The substantive factors that connect a person with a state would be tested under this approach. This would be done by establishing whether a company carries on an active business in the Contracting State, or whether the management and control of the company is carried out in the Contracting State.6

Gooijer proposes to require sufficient nexus as a prerequisite to be able to be seen as a treaty resident.7 Following the approach taken in the active business test that is included in the LOB provision, the activities of a group of companies in a country could be considered on a consolidated basis, while the legal structure of those activities is no longer of relevance. Additionally, a sufficient nexus requirement can also be introduced by making a connection with the permanent establishment concept in art. 5, par. 1, OECD MTC to define treaty residence.8 Gooijer prefers making a connection with the permanent establishment concept, as most OECD countries are not familiar with the expressions used in the LOB provision.9 A disadvantage of making a connection with the permanent establishment concept is that it requires physical presence in a country. As such, it would require putting more emphasis on a heavily criticized part of the OECD MTC.

Both solutions described by Gooijer essentially require a certain level of activities in a state to be able to benefit from a tax treaty, i.e., requiring a certain amount of substance of an entity as a minimum condition. In both solutions a group approach is applied: whether there is a sufficient economic nexus in a country needs to be established on a consolidated basis. In general, I am in favour of such a more economic approach, as it would contribute to achieving the objectives of the OECD MTC.

In my view, adding the requirement that there should be a sufficient economic nexus with the state to be able to be a treaty resident seems a sensible solution. This would logically require the introduction of the concept of sufficient economic nexus in the OECD MTC and an elaboration on it in the OECD Commentary. Depending on the factors chosen, it should be kept in mind that this can lead to a new variant of tax avoidance: ‘substance tax planning’.10 Combatting this variant of tax avoidance would require truly taking account of the facts and circumstances of a situation. However, if sufficient economic nexus would be measured via a factor presence test as described in par. 6.2.2.4, tax avoidance possibilities seem very limited. Therefore, a factor presence test seems a desirable solution.