Let’s suppose that country X has determined that a specific transaction is somehow abusive of the tax treaty it has signed with country Y. How does country X somehow void the transaction and strip it of its non-sanctioned benefits?
The treaty commentaries offers two viable options; the choice really depends on how treaties interact with local law as defined in that jurisdiction. This question goes to a treaty’s dual status – they are interpreted at a “public international” level (the level of the state and higher) and a domestic level (the level of the state and lower). For a further explanation of how this works, please see Professor Michael Edwards-Ker’s writings on tax treaties.
When the tax treaty is interpreted as being superior to local law, the commentaries offer the following solution:
Other States prefer to view some abuses as being abuses of the convention itself, as op-posed to abuses of domestic law. These States, however, then consider that a proper construction of tax conventions allows them to disregard abusive transactions, such as those entered into with the view to obtaining unintended benefits under the provisions of these conventions. This interpretation results from the object and purpose of tax conventions as well as the obligation to interpret them in good faith (see Article 31 of the Vienna Convention on the Law of Treaties).
As I noted in my first post on tax treaties, they in general have the understood purpose of promoting the exchange of goods and services between countries and increasing the flow of payments between countries. Transactions which do not promote these ends could be considered de facto abusive, giving the state the ability to deny treaty benefits.
When local or domestic law governs treaty interpretation, the commentaries offer the following solution:
Thus, any abuse of the provisions of a tax convention could also be characterised as an abuse of the provisions of domestic law under which tax will be levied. For these States, the issue then becomes whether the provisions of tax conventions may prevent the application of the anti-abuse provisions of domestic law, which is the second question above. As indicated in paragraph 22.1 below, the answer to that second question is that to the extent these anti-avoidance rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability, they are not addressed in tax treaties and are therefore not affected by them. Thus, as a general rule, there will be no conflict between such rules and the provisions of tax conventions
Put in less formalistic terms, should the domestic law govern, the tax treaty does not void nor have any voice in the application of that jurisdiction’s anti-avoidance law provisions. As an aside, almost all jurisdictions have some type of “substance over form” doctrine. In the US this is referred to as the “economic substance” doctrine and has been formally codified. But regardless of the specific name, most jurisdictions have some set of rules to apply in this situation.
In my last blog post, I noted that, according to the OECD’s treaty commentary, there are several purposes for which the tax treaty was written. The two specifically mentioned are to promote the “exchanges or goods and services and the movement of capital and persons.” The treaty also has an anti-avoidance and anti-evasion policy. It is to this point that we now turn.
The anti-avoidance test is found in the treaty commentaries:
9.5 It is important to note, however, that it should not be lightly assumed that a taxpayer is entering into the type of abusive transactions referred to above. A guiding principle is that the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions
This is a two prong test. First, the taxing authority must prove one of the main reasons for entering into the transaction was to obtain a more favorable tax treatment. This is a subjective inquiry. Next, the taxing authority must prove obtaining that benefit would contrary to the “object and purpose of the relevant provisions.” This is an objective inquiry into the section's purpose. It’s important to remember that both elements must be present. Let’s take this in the order presented.
Determining whether securing tax benefits was a main purpose for entering into the transaction is an inquiry into the participant’s subjective intent. Under US law, this requires a very in-depth treatment of the relevant facts, where all material is used to make the determination. Sales literature is a very popular method of proof, as is contemporaneously prepared documentation (reports, memos etc..) used to communicate with others in an organization. Email can also be very revealing, as the informality of this medium may encourage more freedom to say exactly what is on the writer’s mind.
In addition to determining the taxpayer’s subjective intent, we must also rule if granting the benefits of a particular section (which probably means beneficial tax treatment) under conditions proposed by the taxpayer’s transactions would violate that sections purpose. For example, sections 10, 11 and 12 of the treaty allow for preferential tax treatment of cross-border flows, the purpose of which is to promote the remittances between counties. But inherent in each of these sections is the requirement of actual and meaningful activity. For example, a dividend is paid after a company has excess earnings and profits. Interest is paid after one company negotiates a loan and another company agrees to extend credit. Royalties are paid after an intellectual product is developed and the rights to use it are sold to a third party.
These are very complex questions to answer. If you have any questions regarding this, please contact me domestically at 832.330.4101 or over Skype at the name bonddad.
A little commented on section of the OECD Model Tax Treaty is its anti-avoidance sections. In fact, there are several pages of discussion on this issue in the commentary on Section 1 (see paragraphs 7-25). For the next few blog posts, I want to turn to a discussion of this issue as it relates specifically to the OECD Model Treaty and more generally international planning.
Let’s begin at paragraph 7, the first in the explanation’s section on “Improper Uses of the Convention.”
The principal purpose of double taxation conventions is to promote, by eliminating international double taxation, exchanges of goods and services, and the movement of capital and persons. It is also a purpose of tax conventions to prevent tax avoidance and evasion
The convention’s primary purpose is to make it easier to move goods from point A to point B by eliminating the biggest problem facing international trade: double taxation. The tax treaty does this by allowing for the taxation of goods at a jurisdictional nexus (some type or permanent establishment or formal agency in a jurisdiction where the transaction occurs) and granting those companies taxed on this transaction a credit or deduction in their home country (assuming they are taxed on their world-wide income).
For example, a US Company X sells goods through a bricks and mortar store in Germany. Because the US has a world-wide taxation system, this transaction may be subject to tax in two locations: in Germany at the point of sale and in the US on the base company’s total income "from all sources, whatever source derived." But under the tax treaty (and corresponding US law), the Company X is granted a tax credit on its US tax which in theory should eliminate the negative earnings impact of the German Tax.
In the Model Treaty, the above transaction would come under Sections 5 (Permanent Establishment) and sections 23 (Method of Eliminating Double Taxation. See also section 7 on agency.)
The treaty also encourages cross-border flows of capital. Here the biggest impediment is high taxation at the country’s border of dividend, interest or royalty payments. For example, country X imposes a 30% tax on a payment of interest or royalties moving from within to another country. To eliminate this problem, cross-border payments are typically taxed at a lower rate under tax treaties. (See general sections 10, 11 and 12).
So far, we know the tax treaties are supposed to encourage international trade in goods. Next time, I’ll start to look at how they eliminate or discourage tax avoidance and evasion. Should you have any questions, please contact me domestically at 832.330.4101 or internationally via Skype, where my name is bonddad.
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