Posting: 070

October 20, 2014

BEPS and Treaty Abuse – I

On September 16, the OECD dumped on us the first 7 “deliverables” (why not “deliveries”) of the 15 “actions” forming the BEPS project. The slough of material – 736 pages in all – includes reports on the digital economy, hybrid mismatches, treaty abuse, harmful tax practices, transfer pricing of intangibles, country-by-country reporting, and the development of a multilateral treaty. All of the reports are available at

When the OECD announced the BEPS project in 2013, it promised to deliver these 7 action items by September 2014, and it has done so. However, don’t be fooled – there is a great deal of follow-up work to be done on all of these issues. In this regard, the 7 deliverables just issued should really be seen as interim rather than final reports. It is a little too early for victory to be declared.

The amount of work produced is quite remarkable and, even more remarkably, the quality of the work is generally pretty good. The OECD/G20 countries should feel good about how much they have done in such a short time. Unfortunately, they do not have the luxury of taking a deep breath and relaxing for a bit because they have follow-up work on these 7 “deliveries” and even more work on the 8 remaining “deliverables.” The OECD Secretariat and the country delegates must be exhausted.

In this report, I want to make some comments on the proposals to deal with treaty abuse, and in particular treaty shopping. The treaty-abuse issue is especially important and timely for Canada in the light of the pending anti-treaty shopping proposals. 

A discussion draft on treaty abuse was released for comments by the OECD in March of this year (see my report 064). After a relatively short period for consultation and a public meeting on April 14-15, the Report, “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances” available at, was finalized in June and presented to and endorsed by the G20 in its Communique of September 21, 2014. 

Many aspects of the final Report are the same as those in the discussion draft. For example, the title and preamble to the OECD Model will be modified to clarify that the Model is not intended to facilitate double non-taxation or treaty shopping. In addition, the Introduction will be revised to set out the tax policy considerations that countries should taken into account when considering whether or not to start negotiations for a tax treaty with another country. Also, the specific anti-avoidance rules proposed in the discussion draft have for the most part been accepted; the holding period to be added to Articles 10(2) and 13(4); the replacement of the place of effective management test tie-breaker rule for dual-resident companies; and the addition of a rule to deal with certain triangular PE cases. Finally, as discussed below, the Commentary on Article 1 will be revised to clarify that the addition of the limitation on benefits provision and the general abuse test to the text of the treaty will not alter the basic proposition, expressed in the current Commentary on Article 1 that the provisions of a tax treaty are not intended to prevent the application of domestic anti-avoidance rules. 

The proposals dealing with treaty abuse and treaty shopping are what I want to highlight in this report. In my view, the March discussion draft intentionally ignored a lot of the subtleties with respect to these issues. It tossed out a wide variety of anti-abuse measures to see if anything might stick. Surprisingly, much more of the smorgasbord of measures survived than I would have thought. However, with treaty shopping being the most important matter, the proposals have become more refined in this Report to reflect the different interests and approaches of the countries. 

The discussion draft recommended that tax treaties should contain a detailed limitation on benefits provision as well as a general anti-abuse rule similar to the rule in paragraph 9.5 of the existing Commentary on Article 1 of the Model (treaty benefits can be denied where a main purpose of a transaction is to obtain treaty benefits and granting such benefits would be contrary to the object and purpose of the relevant provisions of the treaty). Many commentators thought that the application of both a limitation on benefits provision and a general anti-abuse test was overkill.  The United States made it pretty clear that they were not interested in a purpose-based general anti-abuse rule. In the Canadian context, practitioners were against doing anything about treaty shopping but felt that if something had to be done, then our treaties should be renegotiated to include a detailed limitation on benefits provision.

The Report deals with the differences in the national approaches to treaty abuse by requiring that countries must meet a minimum standard in their treaties to protect against treaty abuse, and in particular, treaty shopping. As long as countries effectively address treaty abuse, they will have some flexibility as to how to achieve that goal.

What is the minimum standard? It consists of a statement in the preamble that the treaty is not intended to create “opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this Convention for the indirect benefit of residents of third States”) plus one of the following:

  1. A principal purpose test (PPT) as the general anti-abuse rule is now referred to (the acronym is misleading because the PPT is really a “one of the principal purposes” test); or 
  2. A detailed limitation on benefits provision plus rules to deal with conduit arrangements; or 
  3. A detailed limitation on benefits provision and a PPT.

The PPT and limitation on benefits provision will be included in a new Article of the OECD Model dealing with entitlement to treaty benefits. The proposed wording of the new Article and Commentary are included in the Report. A sample provision dealing with conduit arrangements is also set out in the proposed Commentary on the PPT. A conduit arrangement – think Velcro – is one in which a resident of a contracting state receives an item of income but pays substantially all of that income, directly or indirectly, to a person or persons who are not resident in that State and would not be entitled to equivalent treaty benefits if the income were received directly.

The statement in the preamble that tax treaties are not intended to facilitate non-taxation and treaty shopping is unobjectionable. The idea is that the statement will be relevant for purposes of the interpretation of the treaty in accordance with Article 31(1) of the Vienna Convention. Given the general reluctance of Canadian courts to take purposive interpretation seriously when dealing with detailed statutory provisions, the Department of Finance should not be taking a lot of comfort from this statement of purpose. However, a clear statement such as this one in the treaty itself will be more effective than just having it in the Commentary on Article 1. And note that the Report recommends that the guiding principle in paragraph 9.5 of the existing Commentary on Article 1 will be retained and its application to treaties that do not incorporate the minimum standard will be clarified in the Commentary on the new Article dealing with entitlement to treaty benefits (see paragraph 49 of the Report).

The guts of the minimum standard is found in the choice of a PPT, a limitation on benefits provision plus rules to deal with conduit financing arrangements, or both. The gold standard is both a detailed limitation on benefits provision and a PPT. This is what the Report recommends (paragraph 11). As noted above, however, that the Americans made it clear that they don’t like purpose tests and they wouldn’t be agreeing to them in their treaties, regardless of what the OECD recommended. So, in order to accommodate the United States, the Report says that a limitation on benefits provision like the one the US uses in its treaties meets the minimum standard (not an A grade, but a Pass) as long as it is accompanied by rules, either in the treaty or in domestic law, that deal effectively with conduit arrangements. A limitation on benefits provision by itself is not enough. 

A PPT by itself, however, is sufficient to meet the minimum standard. The proposed PPT reads as follows:

Notwithstanding the other provisions of this Convention, a benefit under this Convention shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all of the relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting the benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Convention. 

Much ink will be spilled in parsing the wording of the new rule – why in the first sentence does it say “it is reasonable to conclude” but later “it is established”? What does “directly or indirectly” mean? – but these need not concern us at this point because we have bigger issues to deal with.

The recommended PPT is similar to the Canadian GAAR except that the PPT applies if one of the principal purposes of a transaction is to get treaty benefits, whereas under the definition of an “avoidance transaction” in the GAAR the primary purpose of a transaction must be to obtain a tax benefit. Therefore, it is questionable that the Canadian GAAR by itself meets the OECD’s minimum standard. Obviously, some transactions or arrangements will be caught by a one of the principal purposes test that will not be caught by a primary purpose test.  This, of course, raises the interesting, and unanticipated, prospect that the GAAR may be amended to adopt a one of the principal purposes test.

According to the Report, the minimum standard will be met if a PPT is included in a treaty. The Report assumes that such a test provides adequate safeguards against treaty abuse and treaty shopping. However, surely the Canadian experience shows that this is not necessarily true. I’m not sure that the result in MIL (Investments) would have been any different under a PPT in the treaty with Luxembourg, and if I were a Finance official I would not be willing to wait for 10 years to find out. The effectiveness of a PPT is dependent on how the rule is interpreted and applied by the tax authorities and the courts. Given the uncertainty, I like the gold standard for Canada – a detailed limitation on benefits provision and a PPT.

The Report’s recommended approach raises some interesting issues concerning the relationship between domestic anti-avoidance rules and the treaty PPT. For example, if a country has a domestic GAAR (or judicial anti-avoidance rules) that is similar to the PPT, does the country have to include the PPT in its treaties? What if, as in Canada and Australia, the domestic GAARs override the treaties? The Report recognizes that all countries are not in the same situation in this regard. Consequently, the Report acknowledges that countries with domestic anti-abuse rules that effectively prevent treaty abuse and conform to the principles in the Report may not need some of the recommended rules. In general, the Report recognizes in paragraph 14 that “[A]s long as the approach that countries adopt effectively addresses treaty abuses along the lines of this Report, some flexibility is therefore possible.” The difficulty, of course, is who determines whether a country’s rules are effective. If it is the country itself, then the minimum standard is not very meaningful. Does this mean that there may be a monitoring process through a Global Forum on treaty abuse similar to the Global Forum on Transparency and Exchange of Information for Tax Matters?

However, the minimum standard raises a more fundamental issue. How are the major treaty shopping countries – Luxembourg, the Netherlands, Switzerland, Ireland – likely to respond to the Report? Like other countries included in the OECD/G20, they have accepted the Report and agreed to meet the minimum standard. The significance of their agreement is not that they will be protecting their own tax bases from erosion through treaty shopping, but that they will be unable to resist the inclusion of anti-abuse rules in the treaty that will protect the tax bases of their treaty partners. In the absence of anti-abuse rules in treaties, taxpayers can argue that such rules are not implicit in the treaty, that domestic anti-abuse rules cannot be applied to override treaty provisions, and that the lack of reciprocal intentions and understandings about anti-abuse rules (see the observations on the Commentary on Article 1 by Luxembourg (paragraph 27.6), Ireland (paragraph 27.5), the Netherlands (paragraph 27.7), and Switzerland (paragraph 27.9)) means that such rules could not be applied unilaterally.

So what does all this mean for the Canadian proposals in the 2014 budget to deal with treaty shopping? The question is whether those proposals, if enacted, would meet the minimum standard established in the Report. The answer is unclear. Although the proposed Canadian rules are not like the detailed limitation on benefits rules in the Report, they resemble limitation on benefits rules and might be described as simplified limitation on benefits rules. The Report recognizes that the limitation on benefits rules might be modified by some countries to reflect constitutional and administrative issues (paragraph 6). Irrespective of the proposed anti-treaty shopping rules, as noted above, the GAAR is not the equivalent of the one of the principal purposes test recommended by the Report. In any event, some of us (there must be at least one other person who thinks the same way I do) think the GAAR isn’t effective against treaty abuses; and the government itself must think the same, or why would it be proposing anti-treaty shopping rules? So I think Canada might find it difficult to go to an OECD meeting or some other international meeting and take the position that our GAAR meets the minimum standard and therefore it is unnecessary for Canada to do anything else. 

Finally, a tease to try and get you back for my next report. The recommendations of the OECD Report on treaty abuse are meaningless if they require the renegotiation of all existing bilateral tax treaties. Surprisingly, the Report does not deal with how the recommendations are to be implemented quickly in order to stop base erosion because that’s in a separate report. The implementation mechanism will be a multilateral convention. The Report on BEPS Action 15, “Developing a Multilateral Instrument to Modify Bilateral Tax Treaties,” which was also released on September 16, 2014, recommends that the OECD and G20 develop a multilateral treaty to implement all of the treaty-related BEPS recommendations, including the treaty-abuse recommendations. Such a multilateral convention raises many fascinating questions, which will be discussed in my next report.