Do recent tax treaties give too much attention to limitation on benefits and anti-abuse rules and too little to the avoidance of double taxation?

Transcription

1 Do recent tax treaties give too much attention to limitation on benefits and anti-abuse rules and too little to the avoidance of double taxation? I. Introduction 1. In a globalized world, companies and business are developing activities in a number of different countries. Modern business is now defined in a number of new expressions and terms such as ecommerce, just-in-time, on-demand, home-office etc. The new functional and organizational environment that these new developments have brought impacted the analysis of tax treaties and their application. 2. While in the past bilateral tax treaties could effectively reduce or mitigate the double taxation on international transactions without abuse of their provisions by non-residents in the so-called treaty shopping practices, new complex tax schemes are able to confer inappropriate tax benefits to such taxpayers and has led the governments to take this treaty shopping problem very seriously, utilizing a number of approaches to deal with it. 3. Because of the treaty abuse problems, countries engaged in developing sophisticated techniques to curtail international tax planning such as anti-conduit rules, limitation of benefits provisions in tax treaties and other anti-abuse rules. The level of discussion and concern generated some situations in which some of these rules may be too harsh on taxpayers who should actually benefit of the tax treaty benefits, but for the existence of these elaborated anti-abuse provisions, they are not able to use such benefits. That leads to the question which will be explored in this paper: do recent tax treaties give too much attention to limitation on benefits and anti-abuse rules and too little to the avoidance of double taxation? 4. But before entering in the discussion whether the recent tax treaties give too much attention to limitation on benefits and anti-abuse rules, it is important to understand the purpose of tax treaties and why such anti-abuse rules started to exist. II. The Problem of International Double Taxation and Ways of Mitigation 5. Because most of the countries have the ability to tax on the bases of territorial source and residence, there are many situations in which the same income may be taxed in two countries, one on the basis of source, and other on the basis of residence or nationality.

2 6. If no adjustment is granted, concurrent taxing jurisdiction by two countries would impair international transactions, investments and transfers of technology. Some of the basic mechanisms of international taxation have as their main objective to eliminate international double taxation. 7. According to the 2010 Organisation for Economic Co-operation and Development ( OECD ) Model Tax Convention on Income and on Capital Condensed Version ( OECD Model and Comments ), p. 9 International juridical double taxation can be generally defined as the imposition of comparable taxes in two (or more) States on the same taxpayer in respect of the same subject matter and for identical periods. Its harmful effects on the exchange of goods and services and movements of capital, technology and persons are so well known that it is scarcely necessary to stress the importance of removing the obstacles that double taxation presents to the development of economic relations between countries. 8. On its turn, Gustafson, Peroni and Pugh 1 identified four principal mechanisms used to deal with the problem 2 : (1) One of the countries may adopt the territorial system and exempt income earned abroad from its tax; (2) One of the countries could follow the capital-export neutrality business and grant a credit against the tax it would otherwise impose for any taxes paid on income earned in the other country; (3) One of the countries may treat the other country tax as a deduction in calculating the net income subject to its own income tax (4) The income tax treaty which, apart from the previous three, is a bilateral approach for reducing double taxation. A tax treaty can be entered between two countries and will preclude one state from exercise its taxing jurisdiction it could otherwise exercise under international law. As an alternative, the tax treaty may allow both countries to tax the income, but limit the amount of the tax that the source country will be permitted to impose. 9. While the three first methods, exemption, foreign tax credit and deductions are unilateral mechanisms for mitigating double taxation, the income tax treaty is a bilateral device. One of the main advantages of the tax treaties over the unilateral mechanism is the possibility of dividing, in effect, the tax revenues between the signing parties, using the exemption or the credit method as tools to achieve this result. Simply putting, as summarized by OECD, the difference between the methods is that the exemption methods look at income, while the credit methods look at tax 3. 1 Gustafson, Peroni & Pugh, Taxation of International Transactions Materials, Text and Problems (Thomson/West, 3d ed. 2005) p There is another mechanism, not so common, which is the multilateral treaties. 3 OECD Model and Comments, p

3 10. Through the treaty, the country of source surrenders (or shares with) the country of residence taxing powers over specific types of income. In other words, a treaty reduces or eliminates one country taxes ( A ) on certain items of this country sourced income earned by residents of the other treaty party ( B ) and reduces or eliminates income taxes imposed by the other country (B) on certain items of income earned by residents of the first country (A) from sources in that country (B). Additionally, the treaty will allocate taxing jurisdiction over certain items of income earned exclusively to the recipient s country of residence, such as capital gains, for example. 11. Therefore, the premise of the mechanisms to mitigate double taxation, and of the bilateral tax treaties in force, is that the source country in which the income is generated and earned has the initial jurisdiction to tax such income. This principle stems out of the tax sovereignty principle in which the source country has the right to impose tax on income arising in its territory before it leaves the country. These are the most common approaches to mitigate or eliminate double juridical taxation. III. The Role of Tax Treaties 12. As previously discussed, the main purpose of the Tax Treaties is to provide relief from double taxation on income earned on international transactions. The tax treaty represents a commitment of each of the treaty partners to reduce double taxation by eliminating or mitigating the tax on income earned by a resident of the other treaty partner. 13. Also, the principal significance of the tax treaties is that they do not reduce or eliminate the tax in the country of residence, but rather they mitigate or eliminate foreign taxes on specific types of income, such as dividends, interest, royalties etc. These reductions are of great importance to many residents that are not able to offset their tax credits allowed under the unilateral approaches used to mitigate double taxation. 14. According to OECD Model and Comments, p. 56: 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. 15. Therefore, the purpose of tax treaties is to prevent taxes from interfering with the free flow of international trade and investment. Their basic thrust is the avoidance of international double taxation by limiting the jurisdiction that each country may exercise to tax income from domestic sources realized by residents of the other treaty party. Additionally, they develop an important role in providing clarification in certain areas in which the application of tax laws of the treaty partners may not be clear. Also, one of the purposes of the tax treaties is the prevention of tax avoidance and tax evasion. At last,

4 some of the tax treaties also contain clauses providing for cooperation between the taxing agencies of the respective tax partners in matters of tax collection and tax enforcement. IV. The Treaty Abuse Problem 16. The treaty benefits and tax reductions are generally made available to resident of both treaty parties. Usually tax treaties defines resident as a person who, under the tax laws of that country, is liable to tax therein by reason of domicile, residence, citizenship, place of management, place of incorporation or any other criterion of similar nature. When a taxpayer is regarded as a resident of both countries under their respective laws and the general tests in the treaty, the so-called tie-breaker rules come into play. 17. A corporation organized under the laws of its treaty partner is entitled to the tax treaties reductions. The relative ease of corporate organization and operation has lead foreign investors residing in a country that has no tax treaty with the parties (or has a less favorable treaty with one of the countries) to incorporate in a country that has a favorable treaty with the country this taxpayer intends to do business within. 18. An emblematic case that exemplifies the abuse of tax provisions is the U.S. Tax Court case Aiken Industries, Inc. v. Commissioner 4. Aiken Industries was a US Corporation who owned 100 percent of the stock of MPI, which also was a U.S. corporation. On its turn, ECL, a Bahamian corporation owned percent of the stock of Aiken Industries and all of the stock of CCN, an Ecuadorian corporation. CCN became the owner of 100 percent of Industrias, a new corporation organized in Honduras. 19. ECL loaned cash to MPI in exchange for a promissory note with a four percent interest rate. If MPI had paid interest to ECL, the U.S. would have imposed a withholding tax of thirty percent on the interest payments 5 and MPI would have been required to withhold the tax 6. Trying to avoid the withholding tax on the interest payments from MPI to ECL, ECL assigned the promissory note to Industrias in Honduras in exchange for four percent promissory notes from Industrias. MPI would now make payments to Industrias, and the interest payments would qualify for the treaty between the U.S. and Honduras which would case the interest payments not to be subject to tax 20. The court said that Industrias, while a valid Honduran corporation, was a collection agent, with respect to the interest received from MPI. Industrias was merely a conduit for the passage of interest payments from MPI to ECL and the court held that MPI cannot said to have received interest as of its own 4 56 T.C. 925 (acq.) Section 881 of the Internal Revenue Code (26 U.S.C.). 6 Sections 1441 and U.S.C.

5 21. The case can be summarized by the following diagram: 22. This conduit financing arrangement is one good example of the use of tax treaties for the avoidance of taxes. Because of these schemes, most of the recent treaties contain limitation on benefits provisions that prevent tax evasion. 23. On a number of times, the country in which the corporation is established is a tax haven itself or favorable tax jurisdiction so the corporation will be subject to little or no tax in that country. Furthermore, the corporation has little or no economic presence in the treaty country. Because of that, the main purpose for incorporating in the treaty country in the treaty country is to take advantage of the country s tax treaty with the country this taxpayer intends to have business with. Accordingly, unless there is a mechanism in the treaty that curtails such practice, foreign investors will be able to obtain tax treaty benefits in their treaty country of choice merely by setting up a corporation in that country. 24. The governments are using a few approaches to curtail treaty abuse practices. First, the governments may succeed in arguing that the corporation established in the treaty country did not in substance received the income as to which it was claiming tax treaty protection or benefits but was a mere conduit for receiving the income by its shareholders, foreign residents in some other country.

6 25. Second, the governments may include anti-treaty shopping provisions in their domestic codes, applying to a particular provision. Third, the governments may enact general anti-abuse or anti-conduit rules in their codes, providing the tax administration with broad powers to re-characterize certain transactions in accordance with their substance and economic purpose. In this situation, the ultimate owner of the income may not be the interposed corporation formed in the treaty party for purposes of treaty shopping. 26. Another approach, this one bilateral, is to include limitation-of-benefits provisions in the tax treaties. These provisions may vary in their application but the generally provide that certain benefits conferred by a tax treaty are not available to a corporation formed in the treaty country if more than a specified percentage of its shares is held by residents of other countries other than the treaty parties. 27. Another issue relates to the interaction between domestic law and tax treaties on preventing abuses. This raises two fundamental questions as pointed out in the OECD Comments, p. 60: whether the benefits of tax conventions must be granted when transactions that constitute an abuse of the provisions of these conventions are entered into and whether specific provisions and jurisprudential rules of the domestic law of a Contracting State that are intended to prevent tax abuse conflict with tax conventions. 28. For a number of countries, the domestic law is the instrument in which the taxes are imposed. Such tax obligation may be restricted (or broadened) by tax treaties. Taking that into account, the treaty abuse is viewed as an abuse of the domestic tax law which imposes the tax. In this case, the issue is whether tax treaties override or prevent the application of domestic tax law anti-abuse provisions. In fact, as a general rule, if the domestic rules were not addressed in tax treaties, they should not be affected by them. 29. Other countries hold the view that abusive transactions do not necessarily violate domestic tax laws, but rather, they violate the treaties themselves. In this sense, the correct interpretation of the tax treaties would imply that they disregard abusive transactions entered into in order to obtain unintended benefits under the treaties. As indicated in the OECD Comments, p. 61, this understanding stems out of the object and purpose of tax conventions, as well as the obligation to construe them in good faith (Article 31 of the Vienna Convention on the Law of Treaties). 30. Irrespective of the position adopted, the treaty partners do not have to apply the benefits of the tax treaty if the taxpayer made arrangements that characterize as an abuse of the tax treaty provisions. 31. Additionally, another important tool of the tax treaties in order to combat the improper use of tax treaties and international tax evasion is the clause that allows treaty parties to exchange information to combat such abuses.

7 V. The Conflict Between Double Taxation and Tax Avoidance Provisions in Tax Treaties 32. As already emphasized, the main objective of tax treaties is to help increase exchanges of goods and services and the movement of capital and individual by eliminating or mitigating double taxation. However, preventing tax avoidance and evasion is also a purpose of tax conventions. 33. While the use of tax treaties as an instrument for avoiding tax evasion is important, there are occasions in which the remedy can be worse than the disease. Tax provisions aiming to avoid abusive transactions will impair or put the taxpayer who regularly conduct its business between the two treaty parties in a situation of double taxation. 34. In fact, even though undesirable situations may come into play, the tax treaties have developed mechanisms to mitigate or to assure that double taxation does not occur. If juridical double taxation arises, and the rules designed to attribute one type of income to a specific country in the event of double taxation ( tie breaker rules ) are not sufficient to tackle the problem, the taxpayer can rely on the tax credit provisions in domestic law and under the treaty. Additionally, almost all tax treaties contain a clause in which both treaty parties can engage in solving the double taxation problem by a friendly proceeding called mutual agreement procedure. 35. It is true that the biggest discussions in the recent treaties tend to focus more on how to curtail new mechanisms and schemes developed by creative taxpayers to abuse the tax treaty or to obtain treaty benefits on transactions that should not be entitled to such benefits. Nevertheless, on the other side, while the creativity of the taxpayers is endless, the general principle that guides the elaboration of tax treaties remains the same: to prevent double taxation. 36. Having said that, it is important that new tax treaties and new anti-abuse or limitation on benefits provisions are designed based not only with the purpose of avoiding the tax evasion, but also to assure that, by eliminating double taxation, the tax treaties will achieve their main goal, which is to eliminate double taxation. VI. Conclusion 37. Because there are situations in international transactions in which the same event or activity may be the taxable basis of two or more different countries, juridical double taxation may come into play. Such phenomena has a great impact on the exchange of goods and services, free movement of individuals, capitals and technology. In order to mitigate or completely eliminate the double taxation, there are unilateral, bilateral and multilateral approaches. Under the bilateral, approaches, tax treaties have been proven to be efficient mechanisms to deal with the problem.

8 38. The purpose of tax treaties is to prevent taxes from interfering with the free flow of international trade and investment. Their basic thrust is the avoidance of international double taxation by limiting the jurisdiction that each country may exercise to tax income from domestic sources realized by residents of the other treaty party. Additionally, they develop an important role in providing clarification in certain areas in which the application of tax laws of the treaty partners may not be clear. Also, one of the purposes of the tax treaties is the prevention of tax avoidance and tax evasion. At last, some of the tax treaties also contain clauses providing for cooperation between the taxing agencies of the respective tax partners in matters of tax collection and tax enforcement. 39. There are situations in which the tax treaties are used to avoid or reduce taxes inappropriately. Residents of states that are not parties to the treaty or do not conduct business activities in such country interpose companies or utilize schemes to benefit from the treaty reductions or exemptions. Because of that, the governments have effortlessly tried to prevent these situations from happening by designing anti-abuse rules and limitation on benefits of the treaties. 40. In fact, while the development of rules to combat tax evasion under the treaties is a continuous given the creativity of the taxpayers to generate loopholes by using sophisticated techniques, the main purpose of the tax treaties is still the avoidance of double taxation. Therefore, new tax treaties, despite containing a lot of anti-avoidance provisions still contains the most important rules to combat double taxation. The biggest challenge, therefore, is to adjust these new rules in order to accommodate all situations in which taxpayers should, effectively, receive relief from double taxation. Error! Unknown document property name.