3.3.5.4 Art. 29 OECD MTC: Entitlement to benefits

Introduction

Art. 29 OECD MTC is part of the Model Tax Convention since the 2017 update and is consistent with the simultaneously amended preamble to the OECD MTC. That preamble expresses that Contracting States apply tax treaties with the aim to eliminate double taxation with respect to income and capital, without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty shopping). Art. 29 OECD MTC includes three variants of anti-abuse provisions: a LOB provision; a provision related to permanent establishments in third jurisdictions; and a general anti-abuse provision (the Principal Purpose Test, PPT). Contracting States may choose to include one or more of these provisions in their treaties.1

The anti-avoidance provisions of the OECD MTC deny access to the treaty or access to certain treaty benefits. This meets the objective of the OECD MTC to prevent tax avoidance. The fight against tax avoidance can, however, lead to double taxation. After all, if the OECD MTC or a specific provision of the OECD MTC does not apply, both Contracting States can apply their national law without restriction.

The LOB provision

Introduction

Based on certain characteristics2 of a person, the LOB provision3 tests whether or not this person is entitled to treaty benefits.4 The LOB provision considers the person as such, so the assessment does not include the motive of a certain transaction or arrangement. The LOB provision is applied according to an exhaustive set of objective criteria. The LOB provision basically applies an ‘all or nothing’ approach: a person either qualifies or not. Applying the provision may mean there is no entitlement to treaty benefits, while there is no treaty abuse. In order to avoid overkill, Contracting States may still decide to grant the benefits in such situations. The OECD MTC provides for both a simplified and a detailed LOB provision. In various paragraphs in the Commentary it is noted that group companies should be taken into account for the application of the LOB provision. These situations are successively discussed below.

Subsidiary of publicly traded companies (art. 29, par. 2, sub d,5 OECD MTC)

A publicly traded company can be a qualified person as referred to in art. 29, par. 2, OECD MTC. The background to this is that such a company will usually be widely held and is therefore unlikely to have been established for treaty shopping purposes.6 Under certain circumstances this exception is also applied – under the detailed LOB provision – to affiliates of publicly traded companies and entities.7

Ownership/base erosion test (art. 29, par. 2, sub f,8 OECD MTC)

In certain circumstances, a company is considered to have a sufficiently strong nexus with a state to be entitled to treaty benefits under the LOB provision when applying the ownership/base erosion9 test if at least 50% of its shares are owned by a resident of the same state. For this test, it is important that less than roughly 50% of the turnover is paid on through deductible payments to residents of a third state or to certain other residents of the resident's state. If there are residents in a tax consolidation, fiscal unity, group relief regime or similar regimes (the tested group10), the base erosion test must be applied at the level of the entity as such and at the level of the tested group. As a result, it is more difficult for a taxpayer to meet the test.

Active business test (art. 29, par. 3, OECD MTC)

The concept of connected person11 also plays a role for the application of the active business test.12 The active business test aims to grant treaty benefits to persons who do not fall within the scope of the concept of qualified person. In short, such persons can still claim treaty benefits if they are engaged in the active conduct of a business in the state of residence and the relevant income arises from this business. In general, an item of income arises from the active conduct of a business if there is a factual connection between the actively conducted business and the item of income for which treaty benefits are claimed.13 In this context, the concept of connected person contains a potentially positive group approach for taxpayers on the one hand and has an anti-abuse character on the other. Under certain circumstances, the activities performed by a connected person are attributed to a treaty resident. This may result in more cases in which treaty benefits can be claimed. On the other hand, the activities of the company in the state of residence must be substantial compared to activities performed by a connected person in the source state.14 This prevents undue access to treaty benefits.15

The OECD Commentary explains the application of the concept of connected person in the context of the active business test by using two examples (see figures 3.6 and 3.7).16

The first example is about ParentCo, which is a treaty resident of a third state and is also the parent of HoldCo established in country A. HoldCo holds all the shares in OpCo1 (established in country A) and OpCo 2 (established in country B). HoldCo manages the investments of the group and is not considered to be actively conducting a business. OpCo 2 pays a dividend to HoldCo. The question in this context is whether HoldCo, as the recipient of the income, is entitled to the treaty benefits under the A-B treaty. OpCo 1 and OpCo 2 are active in the manufacturing business. They manufacture the same product in their residence state. For the application of the active business test, the activities of OpCo 1 are attributed to the passive entity HoldCo. However, this is not sufficient to conclude that HoldCo can claim treaty application. What matters is that the dividends paid by OpCo 2 to HoldCo are factually connected to HoldCo's actively conducted business. If the income received does not arise from or is not connected to the business activities of OpCo 1, HoldCo cannot claim treaty benefits. In the example, the dividends are not factually connected to the actively conducted business. Therefore, treaty benefits cannot be claimed based on the active business test.

A second example given in the OECD Commentary relates to the situation where HoldCo (established in country A) holds all the shares in ACo (established in country A) and BCo (established in country B). ACo is active in the manufacturing business. For its manufacturing activities, ACo uses raw materials that are supplied by BCo. When BCo pays a dividend to HoldCo, the question arises whether HoldCo can claim treaty benefits under the A-B treaty. For application of the active business test, the activities of ACo are attributed to HoldCo. In this case the business activities of BCo are seen as factually connected to the business activities attributed to HoldCo, so that the active business test is met. After all, the income received derives from the business activities of ACo. Therefore, a treaty benefit can successfully be claimed in this example based on the active business test.

The examples show that a holding company can, under certain circumstances, claim treaty benefits by attributing the activities of its subsidiary. The active business activities attributable to the holding company must be carried out by a connected person in the same state as where the holding company is a treaty resident. The definition of the term connected person does not require such a ‘country approach’. However, this country approach is logical in light of the objective of the provision. The active business test essentially examines whether there is economic substance in a particular country.17If there is an active business in the state of residence, it is assumed that a company is subject to ‘sufficient’ taxation in its state of residence. The connection required between the activities and the income prevents an entity from being able to intervene to take advantage of treaty benefits.

Derivative benefits test (art. 29, par. 4, OECD MTC)

Under certain circumstances, application of the derivative benefits test18can provide eligibility for treaty benefits of bodies held by treaty residents of third jurisdictions. A condition for granting such treaty benefits is that the underlying persons would have been entitled to equivalent benefits had they received the income concerned directly. In that situation, it is unlikely that the company was interposed to obtain treaty benefits and hence the arrangement selected will not have been motivated by tax reasons.19

Headquarters company test (art. 29, par. 5, OECD MTC)

Under certain circumstances, application of the headquarters company test20 may lead to eligibility for treaty benefits for bodies that are not classified as qualified persons within the meaning of art. 29, par. 2, OECD MTC. The test ensures that an entity that has the function of headquarters company21 within a multinational group22 may be eligible for treaty benefits with respect to dividends and interest received from group companies. The idea behind this is that in such a situation, the volume of the activities is such that invoking treaty benefits is justified.

Interim conclusion: the LOB provision

The LOB provision that is included in art. 29 OECD MTC applies a group approach on several points. This group approach is used to grant treaty benefits in more cases as well as to prevent abuse. Application of the group approach hence extends the scope of the OECD MTC, preventing double taxation in more situations. At the same time, the group approach aims to prevent abuse. Both results meet the objectives of the Model Tax Convention advocated by the OECD.

The provision on permanent establishments in a third jurisdiction

The provision in relation to permanent establishments in a third jurisdiction23 (a triangular case) aims to counter situations of abuse. The treaty abuse referred to in relation to permanent establishments in third jurisdictions is possible if the country of the head office provides relief by not taxing the income from the permanent establishment, while the country of the permanent establishment does not or practically not tax the income either. This is the case if the tax in the third jurisdiction is less than the lower of (1) the amount of that item of income multiplied by a bilaterally determined rate, and (2) 60% of the tax that would be imposed by the state of the head office of the permanent establishment if the permanent establishment would have been situated in that state. If the state of residence (i.e., the state of the head office of the permanent establishment) exempts the profits, the state of source should not provide treaty benefits under the rule. The provision does not apply if the permanent establishment is ‘sufficiently’ taxed or if there is an active permanent establishment to which the income is attributable. In addition, Contracting States may – as with the LOB provision – under certain circumstances decide to grant treaty benefits after all.24

The following is an example of a situation where the abuse to be countered by art. 29, par. 8, OECD MTC may present itself (see figure 3.8).25 Company X from state A holds all the shares in company Y in state B. Y provides a loan to X, for which X pays 100 annual interest. Y has a low-taxed permanent establishment in state C. The domestic corporate income tax rate in state B is 25%, while the rate in state C is only 2%. The A-B treaty provides for a reduced withholding tax on interest payments. This provision only allows state A to withhold a maximum of 10% instead of its national 25% withholding tax on interest. The interest received is attributable to the permanent establishment in state C. Hence, the interest will not be taxed26 in state B, and will only be taxed at a very low rate in state C.27 Art. 29, par. 8, OECD MTC would in this case deny treaty benefits.28

As such, the provision in the context of permanent establishments in third jurisdictions does not include a group approach. In assessing whether or not a permanent establishment exists, the current rules for permanent establishments as contained in art. 5 OECD MTC – including the anti-fragmentation rule that seeks to create a group approach – will play a role. In addition, the provision may encompass group situations, as it addresses situations where, for example, dividends paid by an entity resident in a Contracting State are attributable to a permanent establishment which an entity of the other Contracting State has in a third state.29

The anti-abuse provision for permanent establishments aims to counteract a specific triangular case that may lead to tax avoidance. This contributes to the objectives of the OECD MTC. However, there is no real overarching solution for triangular cases.30 This would require a more comprehensive change of the OECD MTC.

The PPT

The general anti-abuse provision,31 the PPT, is applied to prevent the granting of treaty benefits in situations where, considering all the relevant facts and circumstances, it may reasonably be concluded that obtaining the treaty benefit is one of the principal purposes of the arrangement or transaction which directly or indirectly generated that benefit.32 As an exception to this rule, the treaty benefit is not denied in situations where granting it would be in line with the aim and purpose of the provisions concerned. The term benefit as referred to in the PPT should be interpreted broadly, and may include, for instance, the reduction, exemption, deferral or refund of tax obtained through application of the tax treaty concerned.33

In order to determine whether obtaining a treaty benefit is one of the principal purposes of an arrangement or transaction, an objective analysis of the purpose and intent of all parties involved should be carried out. In this context, all relevant circumstances should be taken into account. For the rule substance and genuine activities are important.34 This concerns substance at the level of the residence country.

The fact that it must be ‘reasonable to conclude’ that one of the principal purposes of an arrangement or transaction was to obtain a treaty benefit seems to imply a relatively limited burden of proof on the tax authorities. After all, obtaining the treaty benefit need not be the sole or principal purpose of an arrangement or transaction.35 Thus, it is not necessary to find ‘conclusive evidence’ of a person's intention in a particular transaction: it is sufficient that, on the basis of an objective analysis of the relevant facts and circumstances, it is plausible that obtaining a treaty benefit was one of the principal purposes of an arrangement or transaction. By contrast, it should not simply be assumed that obtaining a tax benefit is one of the principal purposes of an arrangement or transaction.36 Furthermore, if an arrangement is set up as part of a commercial core activity and the form of the arrangement is not dictated by tax considerations or the achievement of a tax reduction, it is not likely that obtaining a tax benefit was the principal purpose.37 If a situation falls in principle within the scope of the PPT, it is for the person claiming the benefit to demonstrate that the granting of the benefit in the given situation is in line with the aim and purpose of the treaty provision.38 This should be ‘established’. The burden of proof for taxpayers thus appears to be heavier than for tax authorities.39

It is possible to still grant treaty benefits if the optional ‘catch-all’ provision is chosen.40 This provision allows treaty benefits to be granted – at the request of the taxpayer – if those benefits, or other benefits, would have been granted in the absence of the relevant arrangement or transaction. It also requires the Contracting States to consult with each other before denying the request. The catch-all provision is thus a mitigating measure.

Is the choice for the PPT – a generic anti-abuse provision – a choice for legal uncertainty? The PPT can create uncertainty because of its very broad wording and lack of clear explanation.41 De Broe and Luts state that too much discretionary power is given to the tax authorities.42 The broad scope of the PPT can also be seen as an advantage. The PPT may prove to be ‘a very potent weapon in the hands of tax authorities around the world’.43 However, according to Danon a more fundamental reform would be required to address the roots of the problem of treaty shopping effectively.44 Even though the PPT can lead to legal uncertainty, as it is a generic anti-abuse provision providing a ‘last resort’, it seems to contribute to the objectives of the OECD MTC.

In a sense, the PPT contains a group approach to assessing whether there is treaty abuse.45 The provision aims to bring the direct or indirect unwanted claiming of treaty benefits within the scope of application.46 There may be a situation in which a person claims a treaty benefit in relation to a transaction, while a transaction has already taken place beforehand to claim the treaty benefit. As an example, the OECD outlines a situation in which a sister company is used to obtain a more favourable rate of withholding tax on interest within the group.47 If one of the principal purposes of the loan transfer is to obtain the treaty benefit, the transaction falls within the scope of the PPT. According to the OECD, this is not altered by the fact that the loan transfer as such is based on valid commercial reasons. In this case, the driving force behind the transaction is the transferring entity, which seeks to obtain a tax benefit from a group perspective. The pursuit of this benefit then has an effect on the receiving entity.48

The question arises whether, for the purposes of the PPT, a group approach favourable to taxpayers may also be applied, i.e., whether the substance of other group companies in the same country may be taken into account.49 It could be argued that this fits within the more substantive economic approach in the OECD MTC.50 Such an interpretation would probably result in the PPT being effective in fewer situations. This seems to be in line with the casuistic nature of the anti-abuse provision, in which all facts and circumstances must be taken into account.51 In addition, it meets the objectives of the OECD MTC to avoid double taxation without providing opportunities for tax avoidance. Additionally, it would fit within the approach taken for purposes of art. 10 OECD MTC under which granting treaty benefits is still possible if a company is interposed, while the beneficial owner is a resident of the same Contracting State.52

If application of a ‘positive’ group approach for the PPT is not allowed, a group with a large number of entities in a certain country, of which a part has strong relevant substance and a part does not, may be ‘forced’ to adjust the group structure in order to successfully claim treaty benefits. This could for example be the case in a layered and/or fragmented holding company structure. Without a group approach it seems important to centralise all substance in one holding company, to avoid the application of the PPT. Since there can be various reasons for using different holding companies (commercial, legal etc.), this solution seems neither desirable nor intended. Given that there may be a multitude of non-tax reasons for using different entities, it does not seem appropriate to interpret the activities (i.e., substance) of a person claiming a treaty benefit very strictly for purposes of the PPT.

All in all, the PPT applies a group approach with a view to combatting tax avoidance. It is in line with the OECD objectives to apply such a group approach in a positive way for taxpayers. As a result, the PPT applies in fewer situations and overkill can be avoided.