Treaty Platforms: Traps For The Unwary

TAX TREATY PLATFORMS

Traps for the Unwary

Festus Akunobera, Esq.

LL.M., International Tax (NYU); LL.B., 1st Class (MUK); Dip LP (LDC)

Attorney & Counselor at Law (New York, USA); Advocate (Uganda)

CEO, East African School of Taxation

Partner, Akunobera & Akena, Tax & Legal Consultants

Tel. +256 (782) 405-913

Email: [email protected]

Presented By:

March 24, 2010 Centre for Continuing Education, East African School of Taxation

I. BACKGROUND

II. TREATY SHOPPING

III. ANTI-TREATY SHOPPING MEASURES

TABLE OF CONTENTS

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I. BACKGROUND

Reasons for Concluding Tax Treaties

1. To Promote Exchanges of Goods and Services and the Movement of Capital and

Persons, by Eliminating International Double Taxation (See Para. 7 of the OECD

Commentary to Article 1 of the OECD Model Convention).

Illustration 1(a):

Tata, an Indian multinational corporation, is engaged in manufacturing in Uganda. Tata derives

income from its manufacturing operations in Uganda.

• India imposes income tax on its residents‟ worldwide income. Uganda imposes tax on income

derived by foreign corporations from sources in Uganda.

• If there were no tax treaty between India and Uganda, Tata would incur Ugandan tax on

income derived from its manufacturing operations in Uganda (i.e., Ugandan sourced-based

tax) and incur Indian residence-based tax on income derived from its operations in Uganda.

I. Background

4

Reasons for Concluding Tax Treaties (cont’d)

Illustration 1(b):

Tata, an Indian multinational corporation, is engaged in manufacturing in Uganda. Automobiles

manufactured in Uganda are sold in South Africa.

• Assume that income derived from goods manufactured in Uganda is treated as derived from

sources in Uganda. Assume also that income derived from sales of goods in South Africa is

treated as derived from sources in South Africa.

• Tata is at risk of incurring Ugandan source-based tax, South African source based tax and

Indian residence-based tax.

• Would a treaty between Uganda and South Africa alleviate the double taxation problem as

between South Africa and Uganda? – No. treaty benefits are available only to residents of

contracting states, and in our illustration, Tata is resident in neither Uganda nor South Africa.

I. Background

5


There are two principal means adopted under tax treaties to alleviate the double taxation problem:

• The foreign tax credit method. If a resident of a contracting state (“State R”) incurs tax on

income derived from sources in the other contracting state (“State S”), State R must, subject

to limitations, permit its resident to reduce State R tax liability by the amount of State S

income tax incurred on that income.

• The exemption method. If a resident of State R derives income from State S sources, State R

is, subject to limitations, required to exempt that income from State R tax.

Note: Most countries unilaterally grant an exemption or foreign tax credit under domestic law.

A unilateral credit or exemption may not be sufficient where both State R and State S consider

income to be derived from domestic sources. A tax treaty alleviates this problem through

what is called „re-sourcing‟ (i.e., if State S imposes tax in accordance with the terms of the tax

treaty, State R is required to treat the income as foreign source, notwithstanding the provisions

of State R‟s domestic law).

I. Background

6


2. Prevention of Tax Avoidance and Evasion (See Para. 7 of the OECD Commentary to Article

1 of the OECD Model Convention).

• Most tax treaties contain provisions for co-operation between tax administrations of

contracting states through mutual assistance and exchange of information in the collection of

taxes.

• Tax administrations may also exchange other sensitive information related to tax

administration and compliance improvement, for example risk analysis techniques or tax

avoidance or evasion schemes.

I. Background

7

Uganda’s Tax Treaty Network

• Currently, Uganda has 9 tax treaties in force: Denmark (2001), India (2004), Italy (2005),

Mauritius (2004), Netherlands (2006), Norway (2001), South Africa (2001), United Kingdom

(1993) and Zambia (1968).

• The Uganda – Belgium DTT was signed in 2007 but it is not yet in force. The tripartite

Income Tax Agreement between Uganda, Kenya and Tanzania was signed in 1997 but it is not

yet in force.

Status of a Tax Treaty under Domestic Tax Law

• S. 88(1) of the Act provides that an international agreement entered into between the

Government of Uganda and the government of a foreign country or foreign countries shall

effect as if the agreement was contained in the Act.

• S. 88(6) of the Act defines „international agreement‟ as –

– An agreement with a foreign government for the relief of international double taxation

and the prevention of fiscal evasion; or

– An agreement with a foreign government providing for reciprocal administrative

assistance in the enforcement of tax liabilities.

• Note: The definition of international agreement is exhaustive. Therefore, an agreement of the

kind not defined in S. 88(6) is not an international agreement within the meaning of the Act

(e.g., a technical assistance is not an international agreement for income tax purposes).

I. Background

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Status of a Tax Treaty under Domestic Tax Law (cont’d)

• An international agreement takes precedence over the provisions of the Act in the event of

conflict. However, the tax avoidance provisions of the Act (i.e., S. 90 – transactions between

associates and S. 91 - tax avoidance schemes) take precedence over the tax treaty (S. 88(2) of

the Act).

I. Background

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II. TREATY SHOPPING

Meaning of Treaty Shopping

• Treaty shopping typically arises where a person (whether or not a resident of a Contracting

State) acts through a legal entity created in a contracting state essentially to obtain treaty

benefits that would not be available directly.

• Treaty shopping is commonly accomplished through what are known as „conduit‟ entities or

special purpose vehicles.

• The conduit company takes advantage of the treaty provisions under its own name in State S;

economically, however, the treaty benefit goes to persons not entitled to use that treaty.

• The conduit company is usually able to enjoy reduced withholding tax rates or exemption

from capital gains tax in the source country.

II. Treaty Shopping

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Meaning of Treaty Shopping (cont’d)

Direct Conduit Structure

In the illustration below, instead of a United States person investing directly in a Ugandan

company and incurring 15% withholding tax, the United States person invests through a Mauritius

GBC structure. As such, the United States person is able to take advantage of the Uganda –

Mauritius tax treaty, which provides for a 10% rate of withholding tax. Foreign-source interest

received by the GBC is exempt from tax in Mauritius.

II. Treaty Shopping

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United States

Person

SPV (e.g., GBC1)

Limited Company

United States

Mauritius

Uganda

15% Dividend and

Interest Withholding Tax

10% Dividend and


0% Dividend and



Stepping stone conduits

The stepping stone conduit is an advanced conduit structure. In this case, payments received in

State B are subject to tax in State A. However, State A tax is reduced by excessive interest,

commission and other deductions that flow as income to a State C conduit, where they enjoy a

special exemption regime.

II. Treaty Shopping

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State C Conduit

State A Company

Limited Company

State C

State A

State B

Non-treaty Protected

Payments

Treaty-protected

payments

Deductible Payments e.g.,

commissions, interest, etc.

that erode State A‟s tax base

Payments exempt in State C

under a special tax regime Loans, mgt

contracts, etc


• Treaty shopping includes a situation where an individual who has both his permanent home

and all his economic interests in State A, including a substantial shareholding in a State A

company, and who, essentially in order to sell the shares and escape taxation in State A on the

capital gains from the alienation (by virtue of paragraph 5 of Article 13), transfers his

permanent home to State B, where such gains are subject to little or no tax.

II. Treaty Shopping

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Why Treaty Shopping is Undesirable

• Treaty benefits negotiated between two or more states are extended to persons resident in a

non-treaty (“third”) state in a way unintended by the contracting states. On the other hand, as

there is no tax treaty between a third state and the contracting states, residents of the

contracting states would not receive treaty-protected tax treatment with respect to income

derived from the third state. Thus, the principle of reciprocity is breached.

• Income may be exempted from taxation altogether or be subject to inadequate taxation in a

way unintended by the contracting parties. This is especially true if the ultimate beneficial

owner of the income is a resident of a country that follows the exemption system. “Double

non-taxation” is inconsistent with the underlying assumption when negotiating treaties that

income protected from source-country income tax will be taxed in the taxpayer‟s country of

residence or at least falls under the normal tax regime of that state.

• The state of residence of the ultimate income beneficial owner has little incentive to enter into

a treaty with the state of source, because residents of the state of residence can directly access

treaty benefits from the state of source without the need for the state of residence to provide

reciprocal benefits.

II. Treaty Shopping

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III. ANTI-TREATY SHOPPING MEASURES

‘Ownership’ Test under S. 88(5) of the Income Tax Act

A treaty benefit (i.e., exemption from, or reduction of, Ugandan tax) is not available to any

person who, for the purposes of the agreement, is a resident of the other country state where

50% or more of the underlying ownership of that person is held by an individual or

individuals who are not residents of that other contracting state for purposes of the agreement.

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III. Anti- Treaty Shopping: Statutory Measures

Is ≥50% of the underlying

ownership of a State R enterprise

held by an individual or individuals?

Do the individuals that hold ≥50%

of the underlying ownership of a

State R enterprise reside in State R

for purposes of the International

Agreement?

Eligible for Benefits Not Eligible for

Benefits

YesNo

Yes

No

Analysis Framework under S. 88(5)

• S. 88(5) uses the phrase „underlying ownership‟ as opposed to the term „ownership‟. The

phrase „underlying ownership‟ permits an inquiry into the ultimate owners of the enterprise,

not merely its immediate owners.

General Anti-Avoidance Provisions

• S. 88(2) cross-references Ss. 90 and 91 of the Act, as a backstop against treaty-based tax

avoidance schemes. S. 90 is a transfer pricing provision, while S. 91 is a general anti-

avoidance provision.

• S. 91 permits the commissioner to recast/ recharacterise a transaction or an element of a

transaction where –

‾ It was entered into as part of a tax avoidance scheme;

‾ It does not have substantial economic effect; or

‾ The form of the transaction does not reflect the substance

• S. 91(2) defines „tax avoidance scheme‟ to include a transaction, one of the main purposes of

which is the avoidance or reduction of liability to tax.

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III. Anti- Treaty Shopping: Statutory Measures

Conduit Company Cases

A report of the OECD Committee on Fiscal Affairs, entitled “Double Taxation Conventions

and the Use of Conduit Companies”, recommends a number of approaches to counter the

treaty shopping problem.

1. “Look-through” Approach

• Under the look-through approach, a company that is a resident of State R would be denied

treaty benefits with respect to items of income and gains if it is owned or controlled directly

or through one or more companies wherever resident, by persons who are not residents of

State R.

• The look-through approach would ensure that the ultimate beneficiaries of treaty relief are

residents of State R, not residents of third states.

• This approach is too broad. It does not distinguish between abusive transactions and bona fide

business transactions.

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III. Anti- Treaty Shopping: Treaty-based Measures

Conduit Company Cases (cont’d)

2. The “Subject-to-tax” Approach

• Under the subject-to-tax approach, a company that is a resident of State R would be granted

treaty benefits in State S only if the income in question is subject to tax in State R under the

ordinary rules of its tax law. This approach does not offer adequate protection against

advanced tax-avoidance strategies such as „stepping-stone strategies‟.

3. The “Channel” Approach

• The OECD Committee on Fiscal Affairs has recommended a provision similar to the Ugandan

ownership/base erosion test, drafted in the following terms:

“Where income arising in State S is received by a company that is a resident of State R, and

one or more persons who are not residents of State R

a) have directly or indirectly, …a substantial interest in such company, in the form of a

participation or otherwise, or

b) exercise directly or indirectly, alone or together, the management or control of such

company

any provision of this Convention conferring an exemption from, or a reduction of, tax shall

not apply if more than 50% of such income is used to satisfy claims by such persons

(including interest, royalties, development, advertising, initial travel expenses, and

depreciation of any kind of business assets including those in immaterial goods and process”.20



• To ensure that bona fide business transactions are not subject to the proposed anti-treaty

shopping provision, the OECD Committee on Fiscal Affairs has proposed the following

exceptions:

– Where the treaty benefit claimant establishes that its conduct of business and the

acquisition or maintenance of its shareholding or other property, are motivated by sound

business reasons and do not have as primary purpose the obtaining of benefits under the

convention.

– Conduct of substantial business operations in State R and the income with respect to

which treaty benefits are claimed is connected with such operations.

– The tax actually imposed by State R is greater than the reduction of tax claimed in State

S.

– A company resident in State R that has the principal class of its shares registered on

approved stock exchange in a contracting state, or if such company is wholly-owned

directly or through one or more companies, each of which is a resident of a contracting

state, and the principal class of whose shares is so registered.

– Residents of third states have income tax conventions in force with State S and such

conventions provide relief from taxation not less than the relief from taxation under the

convention in question.

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4. The “Exclusion” Approach

• Certain types of companies enjoying tax privileges in State R facilitate conduit arrangements

and raise the issue of harmful tax practices (e.g., the Mauritian GBC1). The OECD

Committee on Fiscal Affairs recommends three alternative ways to tackle the problem of tax

privileged companies –

– Deny the tax benefits to such companies by excluding them from the scope of the tax

convention;

– Insert a safeguarding clause which would apply to the income received or paid by such

companies. Under this approach, tax privileged companies would remain entitled to

treaty benefits but only certain types of income, such as dividends, interest, capital gains

or director‟s fees, are excluded; or

– Deny treaty benefits to a foreign-held company that enjoys a preferential tax regime in

State R, where similarly situated company held by residents of State R would not enjoy

preferential tax treatment in State R.

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5. Beneficial Ownership Requirement

• The OECD Model Tax Convention and all the tax treaties Uganda has concluded contain abeneficial ownership requirement in Articles 10, 11 and 12 (these provisions are based on theOECD Model Tax Convention). Under this requirement, a state is not obligated to give up itstaxing rights over dividends, interests or royalties merely because the income was immediatelyreceived by a resident State R.

• The term “beneficial owner” is not used in a narrow technical sense, rather, it should beunderstood in its context and in light of the object and purpose of the convention, includingavoiding double taxation and the prevention of fiscal evasion and avoidance.

• In practice, beneficial ownership is determined with the assistance of domestic “anti-abuse”provisions such as business purpose doctrine, the step-transaction and substance-over-formdoctrines and conduit principles. Although each case is limited to a particular set of facts,there are a number of common factors which are generally considered by the courts in thecommonwealth as part of a beneficial ownership analysis:

- Title/Possession – whether a taxpayer possesses legal title or has physical possessionof the underlying asset.

- Capitalization – whether the entity holding the asset is adequately capitalized.

- Economic Risk – whether a taxpayer is exposed to the economic risks associated witha particular asset.

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5. Beneficial Ownership Requirement (cont’d)

- Profits – whether a taxpayer is entitled to the profits or income related to a particular

asset.

- Liability – whether a taxpayer assumes the liabilities associated with a particular asset

(e.g., payment of taxes).

- Dominion and Control – whether a taxpayer has the power to make decisions related

to the asset, such as the decision to dispose of the asset.

- Agency Relationship – whether the nature of the relationship between the taxpayer

and the party in possession (legal or physical) of a particular asset created an agency

relationship.

Treaty benefits will be denied if State S successfully asserts that the conduit company

established in a treaty jurisdiction lacks beneficial ownership of the income that is sought to

be protected by the relevant treaty provisions.

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25

SPV

“Issuer”

Parent

Guarantor

Noteholders

Mauritius

Indonesia

loan

loan

Interest subject to

DTA WHT of 10%

Interest not

subject to tax

Indofood International Finance Ltd v JPMorgan Chase Bank,

N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal.

Facts

PT Indofood SM ("the Parent Guarantor") , a company incorporated

in the Republic of Indonesia, carried on substantial business in the

production and distribution of food. It wished to raise capital by issue

of loan notes on the international market. If it had done so itself, it

would have been obliged under Indonesian law to deduct 20% as

withholding tax on interest payable to the noteholders. The rate of

withholding tax could be reduced to 10% if the issue of the loan notes

was made by a wholly owned subsidiary incorporated in Mauritius

and the capital so raised was lent on to the Parent Guarantor on terms

which complied with the conditions specified in the Indonesia -

Mauritius tax treaty. Accordingly, the Parent Guarantor procured the

incorporation in Mauritius of the claimant Indofood International

Finance Limited ("the Issuer").

The Issuer raised US$280m loan notes and lent the capital so raised

to the Parent Guarantor on the same terms. The issue, servicing and

redemption of the loan notes and the loan to the Parent Guarantor

were regulated, inter alia, by a Trust Deed under which JPMorgan

Chase ("the Trustee") was appointed trustee for the noteholders.



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SPV

“Issuer”

SPV

NewCo

Noteholders

Mauritius

Netherlands

loan

Assignment of

Issuer Rights

Onward payment of

interest paid by

Parent Guarantor

Interest not

subject to tax

Parent

Guarantor

Indonesia

Interest subject to

DTA WHT of 10%


N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal

(Civil Division)

Facts (cont’d)

Under terms of the notes, if there was a change in Indonesian law

whereby the obligation to withhold tax from interest payable to the

Issuer exceeded the rate of 10% for which the Mauritian DTA

provided, and "such obligation cannot be avoided by the Issuer

taking reasonable measures available to it", the Issuer might, with

the approval of the Trustee, redeem the notes.

In 2004, Indonesia issued a notice to terminate the Mauritius DTA

effective January 1, 2005, the effect of which would be that the

Parent Guarantor would be obligated to withhold at the rate of

20%. Accordingly, the Issuer gave notice to the Trustee of its

intention to redeem the loan notes. The Trustee refused approval of

the redemption on the grounds that the Issuer had reasonable

measures available to reduce the increased liability for withholding

tax (i.e., that the Issuer assign the benefit of the loan agreement

between the Issuer and Parent Guarantor to a company

incorporated in Netherlands ("NewCo"), which, the Trustee argued,

would have reduced the rate of withholding tax to 10% under the

Indonesia - Netherlands treaty).



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SPV

“Issuer”

SPV

NewCo

Noteholders

Mauritius

Netherlands

loan

Assignment of

Issuer Rights

Onward payment of

interest paid by

Parent Guarantor

Interest not

subject to tax

Parent

Guarantor

Indonesia

Interest subject to

DTA WHT of 10%



(Civil Division)

Issue

Whether the interposition of NewCo between the Parent Guarantor

and the Issuer could reduce the rate of withholding tax in respect of

interest payable by the Parent Guarantor under the loan agreement

to 10% or less - which depended, inter alia, on whether NewCo

could be the beneficial owner of the interest payable by the Parent

Guarantor.

Holding / Observations on Beneficial Ownership

A conduit can normally not be regarded as the beneficial owner if,

though the formal owner of certain assets, it has very narrow

powers which render it a mere fiduciary or an administrator acting

on account of the interested parties (most likely the shareholders of

the conduit company).

One way to test beneficial ownership is to ask: what would happen

if the recipient went bankrupt before paying over the income to the

intended, ultimate recipient?



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SPV

“Issuer”

SPV

NewCo

Noteholders

Mauritius

Netherlands

loan

Assignment of

Issuer Rights

Onward payment of

interest paid by

Parent Guarantor

Interest not

subject to tax

Parent

Guarantor

Indonesia

Interest subject to

DTA WHT of 10%



(Civil Division)

Observations on Beneficial Ownership (cont’d)

If the ultimate recipient could claim the funds as its own, then the

funds are properly regarded as already belonging to the ultimate

recipient. If, however, the ultimate recipient would simply be one

of the creditors of the actual recipient, then the funds properly

belong to the actual recipient.

The meaning to be given to the phrase 'beneficial owner' is plainly

not to be limited by so technical and legal an approach. Regard is

to be had to the substance of the matter. In accordance with the

legal structure, Parent Guarantor is obligated to pay interest two

business days before the due date to the credit of an account

nominated for the purpose of the Issuer and the Issuer is obliged to

pay the interest due in one business day before the due date to the

account specified by the Principal Paying Agent. In both

commercial and practical terms, the Issuer is, and NewCo would

be, bound [by the Note Conditions] to pay on to the Principal

Paying Agent that which it receives from the Parent Guarantor. In

practical terms, the Issuer or NewCo lacked the 'full privilege‟

needed to qualify as the beneficial owner, rather the position of the

Issuer and NewCo equates to that of an 'administrator of the

income„.


6. Place of Effective Management of Subsidiary Companies

• Claims to treaty benefits by subsidiary companies established in tax havens or benefiting from

harmful preferential regimes may be refused where the facts and circumstances suggest that the

place of effective management of a subsidiary does not lie in its alleged state of residence, but

rather lies in the state of residence of the parent company.

• The place of effective management is the place where key management and commercial

decisions that are necessary for the conduct of the entity's business as a whole are in substance

made. All relevant facts and circumstances must be examined to determine the place of

effective management. An entity may have more than one place of management, but it can have

only one place of effective management at any one time.

• Careful consideration of the facts and circumstances may also show that a subsidiary was

managed and controlled in the state of residence of the parent company in such a way that the

subsidiary had a permanent establishment (e.g., by having a place of management) in that state

to which all or a substantial part of its profits were properly attributable.

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Note

Some of the recommended OECD approaches are too generalized (e.g., the exclusion

approach). Leonard Beighton, a former Deputy Chairman of the U.K. Board of Internal

Revenue, is quoted as having noted that the U.K. does not favor general anti-treaty shopping

provisions for the reason that they are likely to hit the wrong targets and create uncertainty;

that the significant degree of discretion they give to officials is undesirable; that they are

likely to be costly and difficult to operate; and that in practice such widely targeted provisions

may not prevent abuse (See “Treaty Shopping: Imitation is Flattering” - [2000] BTR 133).

Most of the anti-treaty shopping approaches recommended by the OECD Committee on

Fiscal Affairs have not been officially incorporated into the model tax convention.

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1. Report of the OECD on Fiscal Affairs – “Double Taxation Conventions and the Use of

Conduit Companies” (2005).

2. Commentary of the OECD Committee on Fiscal Affairs to Articles 1, 10-12 of the OECD

Model Tax Convention (July 17, 2008).

3. Craig Elliffe: “The Interpretation and Meaning of „Beneficial‟ Owner in New Zealand” –

B.T.R. 2009, 3, 276-305

4. Rose Fraser & J.D.B. Oliver: “Treaty Shopping and Beneficial Ownership: Indofood

International Finance Limited v JP Morgan Chase NA London Branch” – B.T.R. 2006, 4, 422-

429.

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III. Anti- Treaty Shopping Measures – Recommended Readings

Thank you

Documents

Treaty Platforms: Traps For The Unwary