BEPS Action 6 — Treaty Shopping Double Whammy

By Philip Morrison, Esq.

Washington, DC 

Way back in the good old days when this commentator served as Treasury's International Tax Counsel, my IRS counterpart and I would sometimes be presented by our staffs with two different approaches for dealing with the same problem.1 Typically, we would endeavor to identify the better approach (more effective, simpler to administer, etc.) and discard the less good one. Unfortunately, for the last decade or more, it appears that tax policy officials, when presented with two different approaches to solving the same problem, often choose both.2 Likewise, the OECD's Discussion Draft, "BEPS Action 6, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances," also suggests adopting two separate approaches. One of them is virtually identical to the U.S. Model Treaty's objective Limitation on Benefits provision (LOB). The other is virtually identical to the "main purpose" subjective anti-abuse rule used in some other countries' treaties. Neither is great, but the objective LOB is far better. To suggest that both be adopted is, to say the least, a bit draconian.

Having both apply, of course, means that a taxpayer must not only go through the complex hoops of the objective LOB, but must also, at the same time, survive a subjective "one of the main purposes" test, a test of unacceptable uncertainty (for both taxpayers and tax administrations). Fail either and there are no treaty benefits. Combining considerable complexity with considerable uncertainty is unworkable.

The subjective "main purpose" test is so uncertain as to be unworkable by itself. That is the reason the U.S. Senate rejected its inclusion in the proposed U.S.-Italy treaty more than a decade ago and why it is exceedingly unlikely that the Senate would ever accept such a provision in the future. Treaties are often intended to attract investment to a residence jurisdiction in order to get source-country treaty benefits. That can be the principal point of the treaty. One of the main purposes of establishing an IP management company or an active internal cash management/financing company in a certain jurisdiction is almost always because that jurisdiction has a broad, favorable treaty network. And if there are people actively managing the IP or financing operations in that jurisdiction, and the owners of the company could get a treaty benefit directly, what is the harm?

Yet the examples the OECD provides come nowhere near blessing such arrangements. Instead, it appears that most structures will fail this subjective test, at least where there has been tax treaty advice given.3 The only suggestion of a safety valve provides virtually no safety. It requires one to prove, given the cross-border investment made in the resident claiming benefits, that obtaining the treaty benefits is "in accordance with the object and purpose" of the treaty. Building a new manufacturing plant is OK. But it appears that active IP or financial management may not be.

Consistency with the object and purpose of a tax treaty is not something that can be identified except in extreme cases. As a former negotiator, I would generally say that the object and purpose is to give reciprocal benefits provided there is sufficient substance to the resident claiming the benefits or its owner would be entitle to such benefits itself. Even where the principal purpose is to obtain treaty benefits, provided there is proof of adequate substance in the residence country, or the owner of the entity in the residence country could receive the same benefits directly, treaty benefits should be available. I shudder to think of the many confusing paragraphs of OECD Commentary that will be written to try to define what "consistency with the object and purpose of the tax treaty" means.

Such a vague, subjective rule cannot work. Taxpayers will never be certain when they are OK and when not. Government tax administrations will have such wide latitude in determining when the rule applies that they, too, will find it impossible to give meaningful guidance to their examiners in the field.

While the U.S. Model LOB is not perfect and is certainly complicated, and while there is uncertainty with respect to some of the terms it uses,4 it has the very great benefit of being objective. As a result, it is administrable, both by taxpayers and their advisors, as well as by government tax administrators. Taxpayers can plan with at least a moderate level of certainty. Government tax examiners can audit a taxpayer structure with a set of rules capable of being applied by ordinary humans. Unlike a main purpose test, the scope of inquiry is both concrete and limited. Thus, the U.S. Model LOB holds potential promise as a means for preventing treaty shopping. Some changes should be examined, however.

Changes that should be considered include some tweaks to the publicly-traded corporation test. The rationale for this test has always been a bit obscure. At one time years ago it may have served as a surrogate for local ownership: if a company was traded on a certain country's stock exchange it was likely to be owned by residents of that country. With global equity markets today, however, that is less likely to be the case. Because of this, the publicly-traded corporation test should not be limited to primary trading on an exchange in the corporation's country of residence. If a U.S. resident corporation is traded on the London exchange, should that disqualify it from getting treaty benefits in its country of residence? Perhaps the focus should be simply on whether it is primarily traded on significant exchanges with significant shareholder protections and in countries that are not tax havens.

The alternative to the local trading test in the more recent U.S. treaties, and an alternative included in the OECD Discussion Draft, is to require a public company to have its primary place of management and control in its country of residence. Superficially, that seems quite attractive. When the definition of "primary place of management and control" is considered, however, it becomes apparent that this rule is impractical for most global multinational enterprises (MNEs). This rule looks to the country in which officers and senior management exercise day-to-day responsibility for "strategic, financial and operational policy" decisions. For many MNEs there is no such place: manufacturing control may be in one place, financial control in another, top strategic thinking and research in a third. Further, depending on what happens in a particular year (a focus on acquisitions or re-financing, for example), the management center of gravity may shift from year to year.

The OECD might also consider why there is no base erosion test in the public company (or the subsidiary of a public company) test. It is not readily apparent why base erosion is a concern if a company is closely held but not a concern if a company is public.

Under the ownership/base erosion test (paragraph 2(e)), the list of "good" base- eroding payment recipients should be expanded. Under the draft, a payee unrelated to the payor that is a same-country subsidiary (same country as the base-eroding payor) of a different-country company that is public or owned by individuals and pensions resident in that country is a "bad" recipient. It is not clear that this makes sense.

Thankfully, the OECD draft includes an active trade or business test. That test, provided it is accompanied by guidance at least as clear as the guidance the United States has,5 and provided the "substantiality" requirement contains a suitably low safe harbor, preferably proportionate to the relative sizes of the treaty partners' economies, is both sensible from a policy perspective and administrable.

Finally, the OECD asks for comments regarding the inclusion of a "derivative benefits" LOB provision.6 In this commentator's practice, the use of such an LOB provision is critical to qualifying numerous cases that present no treaty-shopping policy concerns but that would otherwise not qualify. In adopting such a provision, however, the OECD should allow more than seven equivalent-beneficiary owners. While some limit may be warranted due to administrability concerns, seven is an unnecessarily small number. In addition, if there is any limit, the interaction of the limit with the direct or indirect ownership language must be clarified. Presumably all direct and indirect owners are not counted; otherwise a single public company owner holding the treaty resident through a series of eight tiers of equivalent beneficiaries would not qualify. The concept of ultimate beneficial ownership may be helpful in clarifying what is intended.

In summary, the OECD should discard the "main purpose" test and suggest the adoption of a somewhat altered U.S. Model LOB. Treaty shopping will be prevented in a manner that is both administrable and fair.

This commentary also will appear in the June 2014 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Levine and Miller, 936 T.M., U.S. Income Tax Treaties - The Limitation on Benefits Article, and in Tax Practice Series, see ¶7160, U.S. Income Tax Treaties.


1 We used the term "abuse" a lot less frequently back then.


2 The expanded definition of the term "property" in Reg. §1.954-3 comes to mind, which needlessly added complexity to the doing away of the so-called "its" defense, which is adequately done away with by requiring manufacturing to be done by the CFC's own personnel (as opposed to a contract manufacturer's). See Morrison, "The Atomic Theory of Subpart F," 37 337 (June 13, 2008). 

The expanded definition of the term "property" in Reg. §1.954-3 comes to mind, which needlessly added complexity to the doing away of the so-called "its" defense, which is adequately done away with by requiring manufacturing to be done by the CFC's own personnel (as opposed to a contract manufacturer's). See Morrison, "The Atomic Theory of Subpart F," 37 337 (June 13, 2008). 


3As a technical matter, it is noted that paragraph 29 of the OECD's Discussion Draft speaks of one of the main purposes "of any person concerned with an arrangement or transaction" where treaty benefits might be claimed. Nowhere does this "any person concerned" language appear in the proposed treaty language itself. If a main purpose of "any person concerned" is to be the test, not even the most mundane arrangement will pass muster whenever the taxpayer consults a tax advisor who informs the taxpayer of possible treaty benefits or the lack thereof. That advisor will be a "person concerned" and, of course, pointing out treaty benefits or the lack thereof will be one of his or her main purposes.   




4Exacerbated by the fact that, during the 20+ years of its use, there has been virtually no guidance or court cases dealing with it.


5The United States typically cross-references to the definitions of "trade or business" and "active" under the §367 regulations. 


6As most readers know, such a provision grants benefits to a company where that company is owned by a limited number of equivalent beneficiaries, i.e., persons who could receive the same treaty benefits directly.