1.1 Grounds for the research

Legal entities are usually not fully autonomous but are often part of a larger economic unit. There is often a certain connection with other legal entities, for instance if a legal entity holds all or part of the shares in another legal entity. The question arises under which conditions or circumstances such affiliation should lead to the conclusion that there is a group. Subsequently, the question arises whether the fact that a legal entity is part of a group has or should have consequences for the way in which this legal entity is taxed.

In many countries, a corporation is considered an independent legal entity for the purpose of levying profit tax on entities. In principle, such a legal entity is therefore taxed separately from any shareholders.1 But various provisions of national corporate tax law do not always consider companies to be stand-alone entities. The underlying reasoning for this is, in essence, that following the legal reality would not be appropriate in today's internationally oriented world. It would lead to double taxation and would create opportunities for tax avoidance. For the purposes of taxation, we try to solve this issue with all kinds of ad hoc rules to still reflect the group situation as much as possible. This is the case, for instance, with Controlled Foreign Company (CFC) legislation, taxing low-taxed profits of a controlled foreign subsidiary once again at the level of its parent company. What’s more, a group regime may apply which enables intra-group loss relief under certain conditions. The participation exemption is yet another example of a provision in the national legislation of many countries, which takes into account the existence of a certain connection between companies.

How does the above work out for international group situations involving cross-border income? For tax treaties based on the Model Tax Convention on Income and on Capital 2017 (OECD MTC) of the Organisation for Economic Co-operation and Development (OECD), the starting point is that each individual legal entity must be considered for the application of the treaty.2 This is confirmed, inter alia, in art. 5, par. 7, OECD MTC, which states that the fact that a group company has control over another group company does not mean that the subsidiary is automatically a permanent establishment of the parent company. Such a subsidiary thus constitutes an independent legal entity for tax purposes. From this provision and the related Commentary by the OECD,3 it can be concluded that a subsidiary is a legally independent entity for the application of tax treaties.

In treaty relations, deviation from the principle that entities in a group should be treated as separate entities is exceptional. An example is art. 9 OECD MTC, which states that affiliated entities must act as if they were independent parties. Another clear provision, which takes into account the potential existence of a group, is art. 10, par. 2, OECD MTC. This article provides that a parent company which holds at least 25% of the shares in a subsidiary is eligible for a reduction of withholding tax on dividend payments.

Is it logical to adopt a separate entity approach for the application of tax treaties? In many cases, the legal approach does not reflect the economic reality that an entity is usually part of a bigger enterprise with a shared profit motive.4 Today, most multinational enterprises include hundreds of affiliated companies, often involving complex group structures. From an economic perspective, there may be a single company. This is reflected, for instance, in the consolidation rules that apply for accounting purposes. Also, in areas other than tax law, the group is sometimes taken into account rather than the individual group entities.5

It was stated some time ago that the separate entity approach underlying tax treaties is no longer appropriate in a globalising society.6 As different tax regimes are applied to different types of income, taxpayers can for example recharacterize income7 or can structure transactions to get the best tax result. The fact that there are various situations within group relationships in which the separate entity approach may lead to inconsistencies in the application of treaties can be illustrated best by means of examples. Some stylised examples are given below.

A multinational enterprise consists of three companies in three different countries: country A, country B and country C (see figure 1.1). Company A holds all the shares in company B, which in turn holds all the shares in company C. Under national law, only country C has the possibility to withhold tax on interest payments.8 All three countries have concluded tax treaties with each other. Company C is in need of financing and company A can meet this need. The A-C tax treaty limits the possibility to withhold tax on interest payments to 10%.9 The B-C tax treaty limits the withholding tax on interest payments to 5%. Hence, a direct financing by company A to company C is more unattractive in terms of withholding tax than a financing through company B, assuming that company B can be seen as the beneficial owner of the interest payment from C to B.10 This form of treaty shopping is relatively simple within a multinational group and follows from the fact that a separate entity approach is applied.11 In fact, tax avoidance is facilitated in this example. The loan through intermediary company B has no economic reality. Under a partial group approach, it could be argued that the reduced withholding tax rate of the B-C tax treaty should not be granted. However, it could also be argued that the possibility of withholding taxes in such group relationships should be fully restricted, as under a full group approach the internal loans would not be visible as such. Additionally, the example could lead to residual juridical double taxation. Such double taxation would be the result of the operation of the double tax relief in treaties: the withholding tax is levied as a percentage of the gross amount,12 whereas the net amount is taken into consideration for determining the credit for taxes paid abroad.13

A second example shows that a separate entity approach may lead to double taxation. The structure remains unchanged. In this example, for dividend payments a maximum withholding tax of 10% applies under both the A-B and B-C tax treaties. Under national law, both country B and country C withhold tax on dividend payments. Company C pays a dividend of 100 to its shareholder. Withholding tax at a rate of 10% is deducted. Company B then pays the dividend to its shareholder and 10% withholding tax is deducted once again. On top of that, the dividend payment may be subject to profit tax at the level of both company B and company A. The double tax relief article in both tax treaties in principle provides for the elimination of double taxation for the concurrence of withholding tax and profit tax.14 The fact that income tax has already been paid at the level of company C is irrelevant in this context. So, in this situation, the same dividend distribution is taxed multiple times. This double taxation is caused by the separate entity approach, while the very aim of tax treaties is to prevent double taxation. From an economic perspective, the amount of profit tax on dividend payments should not depend on the number of legal intermediaries. The double profit tax is levied on different entities, which results in economic double taxation. Tax treaties mainly aim at the avoidance of juridical double taxation. Nonetheless, the OECD Commentary explicitly states that economic double taxation of dividends is a major impediment to international investment.15

The OECD’s Base Erosion and Profit Shifting (BEPS) project also implies that – according to the OECD – the separate entity approach is not sufficient in all cases. This is evident, for instance, from the reports on the adjustment of the permanent establishment rules.16 According to the OECD, in certain cases the activities of group companies should be taken into account in determining whether there is a permanent establishment.17 Without such a group approach, the existence of a permanent establishment could easily be circumvented. However, the BEPS project solely closes loopholes instead of re-examining the rules.18 Via the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) countries had the possibility to quickly and efficiently amend their tax treaties to combat tax avoidance in line with the OECD recommendations, without the need for renegotiation.