beneficial ownership: treaty entitlement, including transparent entities oecd – ifa tax...

BENEFICIAL OWNERSHIP: TREATY ENTITLEMENT, INCLUDING TRANSPARENT ENTITIES

OECD – IFA TAX CONFERENCE,MUMBAI23-25 JANUARY, 2008

TARA RAOSTEVE TOWERS

Copyright © 2008 Deloitte. See notice on last page. 2

Agenda

• Treaty Shopping

• Transparent Entities

• Q & A


Agenda

• Treaty Shopping :

– Background

– “Beneficial ownership”

– Indofood and other recent case law on “beneficial ownership”

– Other treaty-based provisions against treaty shopping

– Domestic tax law provisions against treaty shopping

– Case study

– Practical responses

– Unexpected risks


• Q & A


Example of treaty shopping

HK Co

HK

SINGAPORE

Interest

15% w/h tax

SING Co

HK Co

Mauritius Co(GBLC 1)

SING Co

Loan HKMAURITIUS

Loan

0% w/h tax [Mauritius domestic tax law]

Loan

SINGAPORE

0% w/h tax [Singapore/ Mauritius treaty]

Mauritius Co subject to 3% corporate income tax on “spread”

Is Mauritius Co the “beneficial owner” of the interest paid by Sing Co?


Attitude of OECD

• 1986: 2 reports:

– “Double taxation conventions and the use of base companies”

– “Double taxation conventions and the use of conduit companies”

• OECD Commentary: amended in 2003:

– Commentary on Art. 1: “Improper use of the Convention”

– Commentaries on Arts. 10, 11 & 12: Expansion of comments on “beneficial owner” test.


OECD Report (1986) : Conduit Companies

The Report identifies two types of conduit company :

1. Direct conduit¹:

Beneficial owner²

Conduitcompany

Payer of dividend,Interest, royalties,

etc

Third State (State of beneficiary²)

State A (State of conduit)

State B (State of source)

Dividend, interest, royalties, etc

¹ This diagram is adapted from that in Annex 1 to the Report.

² The diagram in Annex 1 calls the resident of the third State, “beneficial owner”. It also calls the third State, “State of beneficiary”.


OECD Report (1986) : Conduit Companies

2. “Stepping stone” conduit¹ :

Beneficial owner²

Conduitcompany

Payer of dividend,Interest, royalties,

etc

Third State (State of beneficiary²)

State D (State of secondary conduit company)

State B (State of source)

Interest, commissions, service fees and similar

expenses

¹ This diagram is adapted from that in Annex 1 to the Report.

² The diagram in Annex 1 calls the resident of the third State, “beneficial owner”. It also calls the third State, “State of beneficiary”.

Secondary conduitcompany (“sink”)

State A (State of conduit)Dividend, interest,

royalties, etc


Tax Authority Responses to Treaty Shopping

• Choice of treaty partners

• Scope of treaties and benefits given

• Use domestic anti-avoidance provisions

• Build in anti-abuse provisions into tax treaties: specific as well as general

• Close examination when determining entitlement to treaty relief, e.g., “beneficial ownership”


Agenda


– Background





– Case study




• Q & A


“Beneficial ownership”

• The “first line of defence” against treaty shopping

• Used in Arts. 10, 11 & 12

• Not defined in most treaties


Art. 10, OECD & UN Models

1. Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State.

2. However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State, but if the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed:

……….”

Note: Bolding added

“

“



1. Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.

2. However, such interest may also be taxed in the Contracting State in which it arises and according to the laws of that State, but if the beneficial owner of the interest is a resident of the other Contracting State, the tax shall not exceed…..”

Note: Bolding added

“

“



OECD Model:

1. Royalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in that other State.”

Note: Bolding added

“

UN Model:

1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in the other State.

2. However, such royalties may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner of the royalties is a resident of the other Contracting Sate, the tax so charged shall not exceed….”

“

“


Netherlands : Stockbroker Case

Issue: Could the UK-resident stockbroker claim the limitation on Dutch dividend withholding tax, under the UK/Netherlands treaty? In other words, was the UK-resident stockbroker “the beneficial owner” of the dividends?

Held: Yes

Per the Court:

“The [UK-resident stockbroker] has, by purchasing the dividend coupons, become their owner. This Court may further assume that the [UK-resident stockbroker] had, after their purchase, the free disposal of the dividend coupons, and after cashing them, of the distributions received and that, when cashing the dividend coupons, it did not act as agent or nominee. Under those circumstances, the [UK-resident stockbroker] may be considered to be the beneficial owner of the dividends.”

UK-residentstockbroker

Luxembourg – resident

shareholder

Royal Dutch Shell

(Netherlands-resident)

① declaration of dividends (+ issue of div. coupons)③ payment

of dividends

② sale of div. coupons

② $

shares


Art. 3(2), OECD & UN Models

• The terms, “beneficial owner” and “beneficially owned”, are not defined in the OECD & UN Models.

• Art. 3(2) :

“ As regards the application of the Convention at any time by a Contracting State, any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of the State for the purposes of the taxes to which the Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State.”

Note: Bolding added


“Beneficial owner” : technical term under common law

• Under common law, the term, “beneficial owner”, would exclude a legal owner who is trustee for another

• OECD Commentary: “The term ‘beneficial owner’ is not used in a narrow technical sense….”

• Assume that one or both of the treaty countries uses the common law meaning in its domestic law. Would Art. 3(2) apply? Consider whether the context would “otherwise require”.

• What is “the context” for the purposes of Art. 3(2)? Would “the context” include the OECD Commentary?


Is it permissible to consult the OECD Commentary to determine the meaning of “beneficial owner”?

Vienna Convention on the Law of Treaties:

“Article 31 : General rule of interpretation

1. A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose.

2. The context for the purpose of the interpretation of a treaty shall comprise, in addition to the text, including its preamble and annexes:

a. any agreement relating to the treaty which was made between all the parties in connexion with the conclusion of the treaty;

b. any instrument which was made by one or more parties in connexion with the conclusion of the treaty and accepted by the other parties as an instrument related to the treaty.

Note: Bolding added

“

“


Is it permissible to consult the OECD Commentary to determine the meaning of “beneficial owner”? (cont’d)3. There shall be taken into account, together with the context:

a. subsequent agreement between the parties regarding the interpretation of the treaty or the application of its provisions;

b. any subsequent practice in the application of the treaty which establishes the agreement of the parties regarding its interpretation;

c. any relevant rules of international law applicable in the relations between the parties.

4. A special meaning shall be given to a term if it is established that the parties so intended.

Article 32 : Supplementary means of interpretation

Recourse may be had to supplementary means of interpretation, including the preparatory work of the treaty and the circumstances of its conclusion, in order to confirm the meaning resulting from the application of article 31, or to determine the meaning when the interpretation according to article 31:

a. leaves the meaning ambiguous or obscure; or

b. leads to a result which is manifestly absurd or unreasonable.”

Note : Bolding added

“

“

“

“


OECD Commentary“12.1 Where an item of income is received by a resident of a Contracting State acting in the capacity of agent or nominee it would be inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption merely on account of the status of the immediate recipient of the income as a resident of the other Contracting State. The immediate recipient of the income in this situation qualifies as a resident but no potential double taxation arises as a consequence of that status since the recipient is not treated as the owner of the income for tax purposes in the State of residence. It would be equally inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption where a resident of a Contracting State, otherwise than through an agency or nominee relationship, simply acts as a conduit for another person who in fact receives the benefit of the income concerned. For these reasons, the report from the Committee on Fiscal Affairs entitled ‘Double Taxation Conventions and the Use of Conduit Companies’ concludes that a conduit company cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties.

“12.2 Subject to other conditions imposed by the Article, the limitation of tax in the State of source remains available when an intermediary, such as an agent or nominee located in a Contracting State or in a third State, is interposed between the beneficiary and the payer but the beneficial owner is a resident of the other Contracting State…”: OECD Commentary (paragraphs 12.1 and 12.2 to the Commentary on Art. 10) [substantially identical comments are contained in the Commentaries on Art. 11 and Art. 12].

First disqualifying

condition

Second disqualifying

condition


Agenda


– Background





– Case study




• Q & A


Indofood

Indofood Mauritius (subsidiary of

Indofood Indonesia)

Interest

Indonesia

Loan (in the form of Notes)

Offshore

Loan (in the form of Notes)

Actual Structure:

Third PartyNoteholders

Indofood Indonesia

Interest

*************************************************************

• Indonesia domestic tax law: 20% interest withholding tax

• Indonesia/Mauritius treaty: 10% (if beneficial owner)

• Indonesia/Mauritius treaty: terminated in 2004

Indofood wanted to redeem the Notes, because of an adverse movement in interest rates and because of the increased “gross up” requirement due to the treaty termination.

The treaty termination allowed Indofood to redeem the Notes, unless it could avoid the additional tax by “taking reasonable measures available to it”.


Indofood

Contractual arrangements in the Actual Structure:

“… [Indofood Indonesia] is obliged to pay the interest two business days before the due date to the credit of an account nominated for the purpose by [Indofood Mauritius]. [Indofood Mauritius] is obliged to pay the interest due to the noteholders one business day before the due date to the account specified by the Principal Paying Agent. The Principal Paying Agent is bound to pay the noteholders on the due date. …. [Indofood Mauritius] is bound to pay on to the Principal Paying Agent that which it received from [Indofood Indonesia] because it is precluded from finding the money from any other source by the Note Conditions…” (Extract from Court of Appeal judgment of the Chancellor) (bolding added)


Indofood

Indofood Netherlands

Interest

Indonesia

Loan

OffshoreLoan

Structure suggested by Trustee for Noteholders:

Third PartyNoteholders

Indofood Indonesia

Interest

****************************************************************

• Indonesia/Netherlands treaty: 0%/10% (if beneficial owner)

Indofood Mauritius

Loan Interest


Indofood

Issues addressed by Court of Appeal:

• Fundamental issue: Would restructuring the loan (as suggested by Trustee) be a “reasonable measure available to” Indofood?

Would the interposed entity (Indofood Netherlands) be entitled to claim 0%/10% rate limitation under the Indonesia/Netherlands treaty? In other words, would Indofood Netherlands be the “beneficial owner” of the interest paid by Indofood Indonesia?

• Consequential issue: Under the Actual Structure, was Indofood Mauritius entitled to claim 10% rate limitation under the Indonesia/Mauritius treaty (prior to termination)? In other words, was Indofood Mauritius the “beneficial owner” of the interest paid by Indofood Indonesia?


Indofood

Leading judgment in Court of Appeal:

“But the meaning to be given to the phrase ‘beneficial owner’ is plainly not to be limited by [a technical and legal approach which focuses on the contractual arrangements]. Regard is to be had to the substance of the matter. In both commercial and practical terms [Indofood Mauritius] is, and [Indofood Netherlands] would be, bound to pay on to the Principal Paying Agent that which it receives from [Indofood Indonesia]…. In practical terms it is impossible to conceive of any circumstances in which either [Indofood Mauritius] or [Indofood Netherlands] could derive any ‘direct benefit’ from the interest payable by [Indofood Indonesia] except by funding its liability to the Principal Paying Agent or [Indofood Mauritius] respectively. Such an exception can hardly be described as the ‘full privilege’ needed to qualify as the beneficial owner, rather the position of [Indofood Mauritius] and [Indofood Netherlands] equates to that of an ‘administrator of the income’.”


Indofood : impact (thus far)

• “Beneficial owner” = international fiscal meaning?

• Public bond market has adapted

• UK tax authority:

– Guidance issued for cases where no tax benefits

– OECD Commentary on “conduits” endorsed

• Indofood not specifically used by other tax authorities/courts. However, presume increasing focus on “beneficial ownership”


Alfa : an Italian ruling

Patentholders

Alfa(US)

Indofood(Indonesia)

• Application for ruling• “Patent intermediary”• “Bundled” patents and sub-

licensed to customers• Customers only have to deal with

Alfa, not individually with all patentholders

• Alfa’s rights to deal with payments from customers restricted

• Nonetheless, not tax motivated “back-to-back”

• Genuine business, and business purpose and value added

Indofood(Indonesia)Customers

(Italy)

PatentholdersPatentholders


Prevost case

• Canadian Court decision awaited

• Argue Dutch holding company not “beneficial owner” because:– Lacks substance in the

Netherlands: no employees or assets, expenses funded by shareholders

– Owned by UK and Swedish shareholders (no Dutch shareholders)

Holding Company(Netherlands)

Prevost(Canada)

UK Shareholder

Swedish Shareholder


Agenda


– Background





– Case study




• Q & A



• Choice of treaty partners• Scope of treaties and benefits given• Use domestic anti-avoidance provisions• Build in anti-abuse provisions into tax treaties:

specific as well as general• Close examination when determining entitlement to

treaty relief, e.g., “beneficial ownership”


Other “treaty-based” provisions against treaty shopping

• “Subject to tax” / remittance rules• Purpose rules• Exclusion of certain entities• Exclusion of certain parts of entities• “Limitation on benefits” (LOB) articles


“Subject to tax” rule

For example:

UK/Oman treaty, Art. 11(1):

“Interest arising in a Contracting State and paid to a resident of the other Contracting State shall be taxable only in that other State if such resident is the beneficial owner of the interest and subject to tax in respect of the interest in that other Contracting State.”

“subject to tax” vs “liable to tax”



Remittance rules

For example, Art. 22 of the Singapore/Thailand treaty:

“Where this Convention provides (with or without other conditions) that income from sources in a Contracting State shall be exempt from tax, or taxed at a reduced rate in that Contracting State and under the laws in force in the other Contracting State the said income is subject to tax by reference to the amount thereof which is remitted to or received in that other Contracting State and not by reference to the full amount thereof, then the exemption or reduction of tax to be allowed under this Convention in the first-mentioned Contracting State shall apply to so much of the income as is remitted to or received in that other Contracting State.”

A similar provision is included in most of Singapore’s treaties. Under Singapore domestic tax law, foreign source income is taxable only if and when it is remitted (or deemed to be remitted) to Singapore.



Purpose rules

For example:

UK/Netherlands treaty, Art. 11(6):

“The provisions of this Article shall not apply if the debt-claim in respect of which the interest is paid was

created or assigned mainly for the purpose of taking advantage of this Article and not for bona fide commercial reasons.”


Exclusion of certain entities

For example, Luxembourg’s treaties routinely exclude “Luxembourg 1929 companies” from treaty benefits – eg. Art. 29 of the Luxembourg / Indonesia treaty:

“This Agreement shall apply neither to holding companies (societes holding) within the meaning of special Luxembourg laws, currently the Act (loi) of 31 July 1929 and the Decree (arrete grand-ducal) of 17 December 1938 nor to companies subject to a similar fiscal law in Luxembourg. Neither shall it apply to income derived from such companies by a resident of Indonesia nor to shares or other rights in such companies owned by such a person.”


Exclusion of certain parts of entities

For example:

Singapore /Luxembourg treaty:

Art. 1 :

“This Agreement shall apply to persons who are residents of one or both of the Contracting States.”

Protocol:

“At the moment of signing [the Singapore / Luxembourg treaty], the undersigned have agreed that with respect to Article 1, branches of an enterprise of either Contracting State located in third countries are excluded from the scope of the Agreement.

……”


“Limitation on benefits” (LOB) articlesA particular feature of US treaties – but also now being adopted by othercountries.

Structure of Art. 22 (LOB article) in 2006 US Model:

1. General rule : residents are entitled to treaty benefits only to the extent provided in Art. 22.

2. Paragraph (2) has 5 subparagraphs, each of which describes a category of residents that are entitled to all treaty benefits:

a) Individuals

b) Contracting States, or political subdivisions or local authorities thereof

c) (i) Publicly –traded corporations or (ii) subsidiaries of publicly-traded corporations

d) Pension funds or tax exempt organisations


“Limitation on benefits” (LOB) articles (cont’d)

e) Two conjunctive tests :

i. “Ownership test” : Legal entity is majority owned by persons who qualify under (a), (b), (c)(i) or (d); and

ii. “Base erosion test” : Less than 50% of the legal entity’s gross income is paid (as tax deductible payments) to non-residents of either country.

3. Active trade or business : Paragraph (3) sets out a test under which a resident that is not generally entitled to treaty benefits under paragraph (2), may receive treaty benefits on certain items of income that are connected to an active trade or business conducted in the residence country.

4. Treaty benefits also may be granted if the competent authority of the source country agrees.

5. Definitions.


Agenda


– Background





– Case study




• Q & A



• Choice of treaty partners• Scope of treaties and benefits given• Use domestic anti-avoidance provisions• Build in anti-abuse provisions into tax treaties:

specific as well as general• Close examination when determining entitlement to

treaty relief, e.g., “beneficial ownership”


Bank of Scotland case

• Typical “dividend strip”• Usufruct contract: dividends

payable on preference shares during three year period

• Bank of Scotland guaranteed:– Repayment of amount initially

outlaid– Margin

Subsidiary(France)

Parent(US)

Bank of Scotland(UK)

Div

iden

ds

Div

iden

ds p

aid

to B

an

k o

f Scotla

nd

Sale


Domestic tax law provisions against treaty shopping

• US: “conduit financing” regulations

• Canada: GAAR extends to misuse of treaties (MIL case)

• Switzerland: 1962 decree• France and Italy: “business

purpose” required• Germany: “substance” and

“business purpose” tests

• General anti-avoidance doctrines and legislation:– “Substance over form” doctrine

(various countries)– US common law anti-avoidance

doctrines (substance over form, step transaction, business purpose, economic substance)

– “Abuse of law” doctrine (various European countries)

– GAARs in, for example, Canada, Australia or Singapore

– Furniss v. Dawson in the UK


Korea

• Aggressive challenger of perceived treaty shopping

• Application of domestic anti-abuse rules

• Proposed amendment to Korea/Malaysia treaty to exclude Labuan from Malaysia

• 2006 Tax Law revisions:– “Substance over form” rule in

international transactions– Clarified doctrine applies to

tax treaties– Special withholding tax

procedures:• Withholding tax on dividends,

interest, royalties and capital gains derived by treaty residents in “blacklisted” locations

• Such treaty residents either obtain upfront ruling from Korean tax authorities, or seek refund of withholding tax

• So far … only Labuan blacklisted


India

Supreme Court of India (Union of India, et al. v Azadi Bachhao Andolan, et al.): treaty shopping via Mauritius was acceptable from India’s perspective, in the absence of specific anti-treaty shopping provisions in the treaty. [Note that this case concerned Art. 13, which does not contain a “beneficial ownership” or other anti-treaty shopping requirement.]


Indonesia

• Government objects to treaty shopping.

• Indonesia unilaterally terminated Indonesia/Mauritius treaty in 2004, due to concerns over treaty shopping.

• Tax authority circular in 2005 on the interpretation of “beneficial owner” in the dividend, interest and royalties articles of treaties.


Agenda


– Background





– Case study




• Q & A


Case study

ACO[resident in Country A]

BCO[resident in Country B]

Loan #1

CCO[resident in Country C]

Loan #2

Base case :• BCO has very small equity. It has no substantive assets or

operations except as described below.

• Country B / Country C treaty is identical to the OECD Model, except that the rate of tax mentioned in Art. 11(2) is 5%.

• Country C domestic tax law : 25% interest withholding tax.

• Country B domestic tax law : nil tax on outbound interest payments.

• 1 January 2008 : ACO lends $100 million (“Loan#1”) to BCO on these terms:

– Term is 5 years (bullet repayment)

– No security

– Interest = 7.00% p.a.

– Interest payable quarterly in arrears

• 1 January 2008 : BCO lends $100 million to CCO on these terms:

– Term is 5 years (bullet repayment)

– No security

– Interest = 7.50% p.a.

– Interest payable quarterly in arrears

• No treaty :

– Country A / Country B

– Country A / Country C

Country A

Country B

Country C

Int.7.5%p.a.

Int.7.0%p.a.


Case study

Additional facts :

1. No ownership relationship between any of the three companies.

2. Corporate income tax rate in Country B = 35%.

3. Country B’s tax law has provisions dealing with tax residency certificates. Under those provisions, the Country B tax authority is not permitted to issue a tax residency certificate to a company like BCO unless various “substance and risk” conditions are satisfied. Assume that all of those conditions are satisfied and thus a tax residency certificate is issued to BCO.



Loan #1


Loan #2

Country A

Country B

Country C

Int.7.5%p.a.

Int.7.0%p.a.


Case study

What changes to reduce the risk?

1. Size of “spread”.

In the base case, the spread is 0.5% (i.e. 50bps). This idea involves increasing the “spread” to say, 1.00% or 1.50%. Obviously, transfer pricing requirements will limit the ability to increase the “spread”.



Loan #1


Loan #2

Country A

Country B

Country C

Int.7.5%p.a.

Int.7.0%p.a.


Case study


2. Practical payment mechanism.

Instead of Loan#1 and Loan#2 using the same interest payment dates (e.g. 31 March, 30 June, 30 September, 31 December), introduce a degree of “staggering” – e.g. change one of the loans to have interest payable semi-annually in arrears, on 15 May and 15 November.



Loan #1


Loan #2

Country A

Country B

Country C

Int.7.5%p.a.

Int.7.0%p.a.


Case study


3. Level of equity in BCO.

Increase the amount of equity in BCO (and reduce the size of Loan#1). If taken to the extreme, this idea would involve funding BCO 100% with equity. This would make sense only if the gross interest income which BCO would receive on Loan#2 would not cause a significant tax liability in Country B – for example, because:

• BCO has tax losses which would not otherwise be used;

• The Country B corporate income tax rate is low; or

• BCO enjoys a special tax incentive in Country B.



Loan #1


Loan #2

Country A

Country B

Country C

Int.7.5%p.a.

Int.7.0%p.a.


Case study


4. Replace Loan#1 with a derivative arrangement which would “base erode” BCO.

For example, Loan#1 might be replaced by :

• a low-interest loan in a relatively strong currency; plus

• a swap (between ACO and BCO, or between BCO and a bank) from that relatively strong currency into dollars (i.e. the currency of Loan#1).



Loan #1


Loan #2

Country A

Country B

Country C

Int.7.5%p.a.

Int.7.0%p.a.


Case study


5. Add other business activities to BCO.

For example, intra-group services (back office, treasury, HQ).



Loan #1


Loan #2

Country A

Country B

Country C

Int.7.5%p.a.

Int.7.0%p.a.


Agenda


– Background





– Case study




• Q & A


Best practice : our view

• Ensure qualify as a “Resident”• Comply with specific anti-

avoidance provisions in treaties– LOB articles– Purpose articles

• Comply with domestic anti-treaty abuse provisions

• Substance (the basics)– Local office– Local knowledgeable directors– Board meeting held in country – Sufficient capitalization – Local bank account– Company accounting, secretarial

and other compliance activities carried on in country

• Substance (additional)– Additional economic activities

carried on or risks assumed– More than a special purpose

holding company

• Financing/licensing structures: avoid blatant “back-to-back”– Increase size of rate spread– Stagger payment dates– Increase equity– Use equity or derivatives to

replace “second leg”– Other opportunities to mismatch


Agenda


– Background





– Case study




• Q & A


Indah Kiat (Indonesia)

• Dutch SPV:

• Issued bonds

• Proceeds lent to Indah Kiat

• Indonesian withholding tax:

• If Indah Kiat direct to bondholders: 20%

• Indah Kiat to Dutch SPV: 10%

• Indah Kiat argued:

• Structure illegal – “tax avoidance”

• Loan (to Indah Kiat) not enforceable

• Indonesian Supreme Court found for Indah Kiat

Dutch SPV

Netherlands

Indonesia

Indah Kiat

Third countries

Bondholders

Borrowing

Interest

w/h tax nil

w/h tax 10%


Indah Kiat (Indonesia)

• Dutch SPV:

• Issued bonds

• Proceeds lent to Indah Kiat

• Indonesian withholding tax:

• If Indah Kiat direct to bondholers: 20%

• Indah Kiat to Dutch SPV: 10%

• Indah Kiat argued:

• Structure illegal – “tax avoidance”

• Loan (to Indah Kiat) not enforceable

• Indonesian Supreme Court found for Indah Kiat

Dutch SPV

Netherlands

Indonesia

Indah Kiat

Indonesia

Bondholders

Borrowing

Interest

w/h tax nil

w/h tax 10%

• Challenge from Tax authorities expected

• But … business partners (!!) may use “Tax” to avoid obligations

• Now must consider!


Agenda• Treaty Shopping

• Transparent Entities :

– Background

– Classification of foreign entities

– Partnerships : OECD Report & Commentary

– Key principles

– Examples

– Acceptance of OECD’s position

– US Model

– Other transparent entities :

– US “check the box” rules : hybrid / reverse hybrid entities

– Trusts

– REITs

– CIVs

• Q & A


Early “mischief” : Canada / US hybrid entity

Bank

US LLCLoan #2

US Subco

Loan #1

Equity

Canada

US

Can Co• Can Co borrows from Bank.

• Can Co forms US LLC (disregarded entity under US check-the-box rules), and injects equity into US LLC.

• US LLC lends to US Subco.

• US tax treatment of US LLC : disregarded entity.

• Canadian tax treatment of LLC : US incorporated company.

Hybrid treatment


Early “mischief” : Canada / US hybrid entity (cont’d)

Bank

US LLC US Subco

Int. #1

Income flows :

Canada

US

Can Co

Int. #2

Div.

US tax treatment :

• Int.#2 : Deductible to US Subco (subject to domestic tax law rules)

• Int.#2 :

(i) not taxable to US LLC (disregarded entity)

(ii) subject to US IWT, at rate limited under US/Canada treaty.

Canadian tax treatment :

• Int.#2 : Not taxable (US LLC is non-resident, and Canadian CFC rules inapplicable)

• Dividend income : Tax-exempt.

• Int.#1 : Deductible to Can Co.


Responses

• US : Enactment of section 894(c)(in 1997).

• OECD :

– 1993 : Committee on Fiscal Affairs formed a Working Group to study the application of the OECD Model to partnerships, trusts and other non-corporate entities.

– 1999 : First (and, so far, only) report from Working Group : on partnerships

– 2000 : Principles of 1999 report were included in Commentary to OECD Model.




– Background

– Classification of foreign entities– Partnerships : OECD Report & Commentary

– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A


Residence Country vs. Source Country : Differences

Classification Differences

– Legal Entity is formed in Residence Country

– How should it be classified in Source Country?

Tax Treatment Differences

– Residence Country and Source Country agree on classification of Legal Entity.

– However, they disagree on tax treatment : transparent vs. taxable entity

Legal Entity



Company 1

Company 3

Country R

Country S

Company 2

Income

Source in Country S

Trust relationship

• The legal system in Country R recognises 4 types of business and investment “entities”:

– individuals

– companies

– partnerships

– trusts

• The legal system in Country S recognises 3 types of business and investment “entities”:

– individuals

– companies

– partnerships

• A trust relationship exists between Company 3 (trustee) and each of Company 1 (beneficiary) and Company 2 (beneficiary) – all of the three companies are resident in Country R.

• Company 3, as trustee, derives income from source in Country S.



Company 1

Company 3

Country R

Country S

Company 2

Income

Source in Country S

Trust relationship

Question: In applying its domestic tax law to the income derived by Company 3 (as trustee), how should Country S treat the trust relationship? Ignore it ?

OECD Partnerships Report:“14. ……[T]he practice of most countries is to …… apply their domestic tax classification to foreign entities on the basis of the foreign law’s legal characteristics of the entity. [Thus, in this example, Country S], for the purposes of taxing the domestic income of a trust established under the law of [Country R], will typically examine the legal characteristics of the trust as they derive from the trust law of [Country R] in order to determine whom it should tax and whether that person should be taxed as an individual, company or partnership, which are the only categories recognised under its tax law.”




– Background



– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A


Fundamental Principle

Fundamental principle in OCED Partnership Report and the Commentary to Art. 1 : the tax treatment in Country R determines the entitlement to treaty benefits

This principle is expressed as follows:

“One broadly based approach would be to recognise as implicit in the structure of the Convention the principle that the source State, in applying the Convention where partnerships are involved, should take into account, as part of the factual context in which the Convention is to be applied, the way in which an item of income arising in its jurisdiction is treated in the jurisdiction of the taxpayer claiming the benefits of the treaty as a resident. If that State ‘flows through’ the income to the partner, then the partner should be considered liable to tax and entitled to the benefits of the Convention of the State of which he is a resident. It may be observed, in that respect, that a partner is still to be considered liable to tax on the income which ‘flows through’ to him where, in the State of residence, tax is not imposed on that income by virtue of, e.g. a participation exemption in the case of dividends or the application of the exemption method for the relief of double taxation in the case of income attributable to a permanent establishment. On the other hand, if the income, though allocated to the


Fundamental Principle (cont’d)

taxpayer under the laws of the source State, is not similarly allocated for purposes of determining the liability to tax on that item of income in the State of residence of the taxpayer claiming the benefits of the Convention, then the source State should not grant benefits under the Convention. In these latter circumstances, the underlying factual premise on which the allocation of taxing rights is based, that is, that the source State is only obliged to reduce its domestic law tax claim where the income in question is potentially liable to tax in the hands of a resident of the treaty partner, is simply not present. This interpretation, which looks at how the partnership’s income is taxed by the State of residence, avoids denying the benefits of tax conventions to a partnership’s income on the basis that neither the partnership, because it is not a resident, nor the partners because the income is not directly paid to them or derived by them, can claim the benefits of the Convention with respect to that income.” (OECD Partnerships Report, paragraph 53).


Country R vs. Country S

Note that this principle stands in contrast to the general position under the Commentary that Country S’s characterisation of the facts must be applied for the purposes of the treaty : see “conflicts of qualification” in Commentary to Art. 23A & B.


Relevant provisions in OECD Model

Art. 1 :“This Convention shall apply to persons who are residents of one or both of the Contracting States.”

Art. 3(1) :“For the purposes of this Convention, unless the context otherwise requires:

a. the term ‘person’ includes an individual, a company and any other body of persons;

b. the term ‘company’ means any body corporate or any entity that is treated as a body corporate for tax purposes;…….”



Relevant provisions in OECD Model

Art. 4 :“For the purposes of this Convention, the term ‘resident of

a Contracting State’ means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof. This term however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.”



Limitation to “real” partnerships

The OECD Partnerships Report is limited to “real” partnerships – i.e. partnerships under civil or commercial law. This is made clear at the very start of the Report :

1. In 1993, the Committee formed a Working Group to study the application of the Model Tax Convention to partnerships, trusts, and other non-corporate entities. This first report by the Working Group…. focuses exclusively on partnerships. The Committee recognises, however, that many of the principles discussed in its report may also apply with respect to other non-corporate entities and therefore intends to now examine the application of the Model Tax Convention to these other entities in light of this report.

“


Limitation to “real” partnerships (cont’d)

2. In this respect, it should also be noted that the references to ‘partnerships’ in this report cover entities that qualify as such under civil or commercial law as opposed to tax law. Thus the term ‘partnership’, as used in this report, does not imply anything about the tax treatment of the relevant entity and should not be confused with a reference to entities, whether partnerships or not, which are treated as transparent for tax purposes.”


“




– Background



– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A


Examples from OECD Partnerships Report

The following scenarios A to P reproduce and analyse most of the examples in the OECD Partnerships Report.

In scenarios A to P, the following are the participants:

• P, a partnership formed under the law of Country P.

• There are 2 partners in P : ACO (x% partner) and BCO (y% partner). Both ACO and BCO are companies. x + y = 100.

• Company X, a company incorporated and resident in Country S.

The scenarios also assume that there is a treaty between each pair of countries and that all treaties are identical to the OECD Model.


ACO BCO

PCountry P tax

treatment: Transparent

Source (but no PE) in Country S

Country S tax treatment:

Transparent

***************************************************************

Country P

Country S

Interest

y%x%

Scenario A (1/4)

• ACO and BCO are resident in Country P.

• Both Country P and Country S treat P as a transparent entity for tax purposes.

• P derives interest income from Country S, but the interest income is not attributable to a PE in Country S.

Question:Who can claim treaty benefits?


ACO BCO

PCountry P tax




Transparent

***************************************************************

Country P

Country S

Interest

y%x%

• P cannot claim benefits under the Country P/Country S treaty.

OECD Commentary on Art. 1:

“5 .. Where, however, a partnership is treated as fiscally transparent in a State, the partnership is not ‘liable to tax’ in that State within the meaning of paragraph 1 of Article 4, and so cannot be a resident thereof for purposes of the Convention. In such a case, the application of the Convention to the partnership as such would be refused, unless a special rule covering partnerships were provided for in the Convention….”

X

Scenario A (2/4)


ACO BCO

PCountry P tax




Transparent

***************************************************************

Country P

Country S

Interest

y%x%

• ACO and BCO can claim benefits under the Country P/Country S treaty.


“5 .. Where the application of the Convention [to the partnership] is so refused, the partners should be entitled, with respect to their share of the income of the partnership, to the benefits provided by the Conventions entered into by the States of which they are residents to the extent that the partnership’s income is allocated to them for the purposes of taxation in their State of residence ….”

√ √

Scenario A (3/4)


ACO BCO

PCountry P tax




Transparent

***************************************************************

Country P

Country S

Interest

y%x%

• ACO and BCO can claim benefits under the Country P/Country S treaty (continued) :


“6.4 .. Where.. income has ‘flowed through’ a transparent partnership to the partners who are liable to tax on that income in the State of their residence then the income is appropriately viewed as ‘paid’ to the partners since it is to them and not to the partnership that the income is allocated for purposes of determining their tax liability in their State of residence. Hence the partners, in these circumstances, satisfy the condition, imposed in several Articles, that the income concerned is ‘paid to a resident of the other Contracting State’ ….”

Note that paragraph 6.4 refers specifically to the “paid to a resident of the other Contracting State” condition; however, it does not refer to the “beneficial ownership” condition in Arts. 10, 11 & 12. Nevertheless, it would be consistent with the theme of paragraph 6.4 for the “beneficial ownership” condition to also be taken to be satisfied in the same circumstances.

√ √

Scenario A (4/4)


ACO BCO


***************************************************************

y%

Country P

Country S

x%

Interest

Country P tax treatment:

Transparent


Transparent

***************************************************************

Country R

Country R tax


P

• ACO and BCO are resident in Country R.

• Countries R, P and S all treat P as a transparent entity for tax purposes.

• P derives interest income from Country S, but the interest income is not attributable to a PE in Country S.


Scenario B (1/3)


ACO BCO


***************************************************************

y%

Country P

Country S

x%

Interest


Transparent


Transparent

***************************************************************

Country R

Country R tax


P

• ACO and BCO can claim benefits under the Country R/Country S treaty.


“6.5 .. Where a partner is a resident of one State, the partnership is established in another State and the partner shares in income arising in a third State then the partner may claim the benefits of the Convention between his State of residence and the State of source of the income to the extent that the partnership’s income is allocated to him for the purposes of taxation in his State of residence ..”

√ √

Scenario B (2/3)




“6.5 .. No benefits will be available under the Convention between the State in which the partnership is established and the State of source if the partnership is regarded as transparent for tax purposes by the State in which it is established…”

Scenario B (3/3)

ACO BCO


***************************************************************

y%

Country P

Country S

x%

Interest


Transparent


Transparent

***************************************************************

Country R

Country R tax


P

√ √

X


ACO BCO


***************************************************************

y%

Country P

Country S

x%


Transparent


Transparent

***************************************************************

Country R

Country R tax

treatment: Taxable entity

P

Business Profits


• Countries P and S treat P as a transparent entity for tax purposes.

• Country R treats P as a taxable entity for tax purposes.

• P derives business profits from Country S, but the business profits are not attributable to a PE in Country S.


Scenario C (1/3)


ACO BCO


***************************************************************

y%

Country P

Country S

x%


Transparent


Transparent

***************************************************************

Country R

Country R tax


P

Business Profits

• ACO and BCO cannot claim benefits under the Country R/ Country S treaty.


“6.5 .. no benefits will be available under the Convention between the State of residence of the partner and the State of source if the income of the partnership is not allocated to the partner under the taxation law of the State of residence..”

X X

Scenario C (2/3)


ACO BCO


***************************************************************

y%

Country P

Country S

x%


Transparent


Transparent

***************************************************************

Country R

Country R tax


P

Business Profits



“6.5 .. No benefits will be available under the Convention between the State in which the partnership is established and the State of source if the partnership is regarded as transparent for tax purposes by the State in which it is established …”

• Thus, no one can claim treaty benefits.


“6.5 .. If the partnership is regarded as transparent for tax purposes by the State in which it is established and the income of the partnership is not allocated to the partner under the taxation law of the State of residence of the partner, the State of source may tax partnership income allocable to the partner without restriction.”

X

Scenario C (3/3)


ACO BCO

PCountry P tax




Taxable entity

***************************************************************

Country P

Country S

Royalties

y%x%


• Country P treats P as a transparent entity for tax purposes.

• Country S treats P as a taxable entity for tax purposes.

• P derives royalties from Country S, but the royalties are not attributable to a PE in Country S.


Scenario D (1/4)


ACO BCO

PCountry P tax




Taxable entity

***************************************************************

Country P

Country S

Royalties

y%x%

• ACO and BCO can claim benefits under the Country P/Country S treaty.

See analysis in Scenario A.

Also, note the following in the OECD Commentary on Art. 1:

“6.4 … [The] conditions that the income be paid to, or derived by, a resident should be considered to be satisfied even where, as a matter of the domestic law of the State of source, the partnership would not be regarded as transparent for tax purposes, provided that the partnership is not actually considered as a resident of the State of source.”

√ √

Scenario D (2/4)


ACO BCO

PCountry P tax




Taxable entity

***************************************************************

Country P

Country S

Royalties

y%x%


See analysis in Scenario A.

X

Scenario D (3/4)


Note that there is a significant difference in Scenario D, as compared to Scenarios A to C. In Scenarios A to C, if there is a party who can claim treaty benefits, that party is also recognised as the relevant taxpayer under the Country S domestic tax law. Specifically :

Party who can Relevant taxpayer underScenario claim treaty benefits Country S domestic tax law

A ACO & BCO ACO & BCOB ACO & BCO ACO & BCOC Nil ACO & BCO

In contrast, in Scenario D, there is a party who can claim benefits (i.e. ACO and BCO), but it is different from the relevant taxpayer under the Country S domestic tax law (i.e. P).

The OECD Partnerships Report comments on this situation as follows:

“60. Under State S domestic law, the taxpayer will be partnership P. State S could then argue that since partnership P is not entitled to the benefits of the treaty, it can tax the income derived by P regardless of the provisions of the S-P Convention. This, however, would mean that the income on which A and B are liable to tax in State P would be subjected to tax in State S regardless of the Convention, a result that seems in direct conflict with the object and purpose of the Convention.

“61. The Committee compared that approach, under which State S applies the provisions of the Convention by reference to the treatment of the partnership under its domestic law, with another approach, under which State S considers the entitlement to treaty benefits of A and B, both residents of State P, under the principles put forward above. Under the latter approach, State S would determine that the provisions of the Convention should be applied to prevent it from taxing the royalties since under these principles, the income must be considered to be paid to A and B, two residents of State P, who should also be considered to be the beneficial owners of such income as these are persons liable to tax on such income in State P. The Committee concluded that this approach was the correct one as it is more likely to ensure that the benefits of the Convention accrue to the persons who are liable to tax on the income.”

Scenario D (4/4)


ACO BCO

PCountry P tax




Transparent

***************************************************************

Country P

Country S

Royalties

y%x%


• Country P treats P as a taxable entity for tax purposes.

• Country S treats P as a transparent entity for tax purposes.

• P derives royalties from Country S, but the royalties are not attributable to a PE in Country S.


Scenario E (1/3)


ACO BCO

PCountry P tax




Transparent

***************************************************************

Country P

Country S

Royalties

y%x%

• ACO and BCO cannot claim benefits under the Country P/ Country S treaty.

See analysis in Scenario C.

X X

Scenario E (2/3)


ACO BCO

PCountry P tax




Transparent

***************************************************************

Country P

Country S

Royalties

y%x%

• P can claim benefits under the Country P/Country S treaty.

“5. Where a partnership is treated as a company or taxed in the same way, it is a resident of the Contracting State that taxes the partnership on the grounds mentioned in paragraph 1 of Article 4 and, therefore, it is entitled to the benefits of the Convention…”

√

Scenario E (3/3)


PCountry P tax treatment:

Transparent

Country R tax


***************************************************************


x% y%

ACO BCO

Country R

Country P

Royalties




• P derives royalties from Country P, but the royalties are not attributable to a PE in Country P.


Scenario F (1/3)



Transparent

Country R tax


***************************************************************


x% y%

ACO BCO

Country R

Country P

Royalties

• ACO and BCO cannot claim benefits under the Country R/Country P treaty.


X X

Scenario F (2/3)



Transparent

Country R tax


***************************************************************


x% y%

ACO BCO

Country R

Country P

Royalties

• P cannot claim benefits under the Country R/Country P treaty.

Note that P would not qualify as a resident of R, for the purposes of the Country R/Country P treaty. Thus, P cannot claim Country P tax benefits under the Country R/Country P treaty.

Scenario F (3/3)

X


ACO BCO

P

Company X

Country R tax



Transparent


Taxable entity

***************************************************************

***************************************************************

Dividend (no PE in Country S)

Country P

Country S

Country R

y%x%


• Company X is resident in Country S.




• P holds shares in Company X.

• P derives dividends from Company X, but the dividends are not attributable to a PE in Country S.


Scenario G (1/3)


ACO BCO

P

Company X

Country R tax



Transparent


Taxable entity

***************************************************************

***************************************************************


Country P

Country S

Country R

y%x%

• ACO and BCO cannot claim benefits under the Country R/ Country S treaty.


X X

Scenario G (2/3)


ACO BCO

P

Company X

Country R tax



Transparent


Taxable entity

***************************************************************

***************************************************************


Country P

Country S

Country R

y%x%

• P cannot claim benefits under the Country R/Country S treaty or under the Country P/Country S treaty.

Note the following comment on Example 7 in the OECD Partnerships Report:

“70. It should be noted that, in this example (as in the following example), the tax treatment of partnerships in State S does not have any impact on the entitlement to treaty benefits. Thus, the S-R and S-P Conventions would still not be applicable with respect to the dividends if State S treated partnerships as transparent rather than taxable entities.”

X

Scenario G (3/3)


ACO BCO

P

Company X

Country R tax



Taxable entity


Taxable entity

***************************************************************

***************************************************************


Country P

Country S

Country R

y%x%









Scenario H (1/3)


ACO BCO

P

Company X

Country R tax



Taxable entity


Taxable entity

***************************************************************

***************************************************************


Country P

Country S

Country R

y%x%

• ACO and BCO cannot claim benefits under the Country R / Country S treaty.


X X

Scenario H (2/3)


ACO BCO

P

Company X

Country R tax



Taxable entity


Taxable entity

***************************************************************

***************************************************************


Country P

Country S

Country R

y%x%

• P can claim benefits under the Country P/Country S treaty, but not under the Country R/Country S treaty.

Note the following comment on Example 8 in the OECD Partnerships Report:

“71. …P should be considered by State S to be entitled to the benefits of the S-P Convention in relation with the dividends it derives from that State as it is liable to tax on those dividends and should therefore be considered to be the recipient and beneficial owner of that income. Thus the S-P Convention will restrict State S right to tax the dividends, even if State S taxes the dividends in the hands of partners A and B under its domestic rules applicable to the taxation of partnerships. It should be noted, however, that since P is a partnership, it will not get the benefits of the reduced rate of tax provided for in subparagraph 2a) of Article 10 of the Model Tax Convention (the subparagraph expressly excludes partnerships from its application)…..”.

√

Scenario H (3/3)


ACO BCO

P

Company X

Country R tax



Taxable entity


Taxable entity

***************************************************************

***************************************************************


Country P

Country S

Country R

y%x%



• Country R treats P as a transparent entity for tax purposes.






Scenario I (1/3)


ACO BCO

P

Company X

Country R tax



Taxable entity


Taxable entity

***************************************************************

***************************************************************


Country P

Country S

Country R

y%x%

• ACO and BCO can claim benefits under the Country R/Country S treaty.

See analysis in Scenario B.

√ √

Scenario I (2/3)


ACO BCO

P

Company X

Country R tax



Taxable entity


Taxable entity

***************************************************************

***************************************************************


Country P

Country S

Country R

y%x%

• P can claim benefits under the Country P/Country S treaty, but not under the Country R/Country S treaty.


“6.5. .. Where a partner is a resident of one State, the partnership is established in another State and the partner shares in partnership income arising in a third State then the partner may claim the benefits of the Convention between his State of residence and the State of source of the income to the extent that the partnership’s income is allocated to him for the purposes of taxation in his State of residence. If, in addition, the partnership is taxed as a resident of the State in which it is established then the partnership may itself claim the benefits of the Convention between the State in which it is established and the State of source. In such a case of ‘double benefits’, the State of source may not impose taxation which is inconsistent with the terms of either applicable Convention therefore, where different rates are provided for in the two Conventions, the lower will be applied. However, Contracting States may wish to consider special provisions to deal with the administration of benefits under Conventions in situations such as these, so that the partnership may claim benefits but partners could not present concurrent claims ..”.

√

Scenario I (3/3)


Scenario J is the same as scenario I , except that :

• Country P is a tax haven

• There is no treaty between Country P and Country S

Question: Who can claim treaty benefits?

Scenario J (1/2)


This scenario corresponds to Example 10 in the OECD Partnerships Report.

ACO and BCO can claim benefits under the Country R/Country S treaty.

See analysis in Scenario B.

OECD Partnerships Report on Example 10:

“78. …. States should not, however, be expected to grant the benefits of a tax convention in cases where they cannot verify whether a person is truly entitled to these benefits. Thus, if State P is a tax haven from which State S cannot obtain tax information, the application of the provisions of the S-R Convention will be conditional on State S being able to obtain all the necessary information from the partners or from State R. In such cases, State S might well decide to use the refund mechanism for the purposes of applying the limitation of tax provided for in Article 10 even though it normally applies this limitation at the time of the payment.”

Scenario J (2/2)


ACO BCO

P

Construction site in

Country S


Transparent


Transparent

Country P

Country S

***************************************************************

x% y%


• ACO carries on a business of engineering and BCO carries on a business of electrical installation.

• ACO and BCO have established a partnership P in Country P for the purpose of a contract to design and install the electrical equipment in a power station being built in Country S.

• As part of the obligations of P under the contract, employees of ACO will be present at the construction site from 1 January to 10 June 2007, and employees of BCO will be there from 10 June 2007 to 1 February 2008.

• Both Country P and Country S treat P as a transparent entity for tax purposes.

Question:Will ACO and BCO each have a PE under Art. 5(3)?

Scenario K (1/5)


ACO BCO

P

Construction site in

Country S


Transparent


Transparent

Country P

Country S

***************************************************************

x% y%

This scenario corresponds to Example11 in the OECD Partnerships Report.

OECD Model

Art. 5(3):

“A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.”

Art. 7(1):

“The profits of an enterprise of a Contracting Sate shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.” (emphases added).

Scenario K (2/5)


Art. 3(1):

“For the purposes of this Convention, unless the context otherwise requires:

(a) the term ‘person’ includes an individual, a company and any other body of persons;………

(c) the term ‘enterprise’ applies to the carrying on of any business;

(d) the terms ‘enterprise of a Contracting State’ and ‘enterprise of the other Contracting State’ mean respectively an enterprise carried on by a resident of a Contracting Sate and an enterprise carried on by a resident of the other Contracting State;

……….”

Initial Comments:

1. A partnership is a “person”, under the Art. 3(1)(a) definition.

2. Partnership P is not a resident of a Contracting State (under the Art. 4(1) definition), because it is treated as a transparent entity in Country P and Country S.

3. Thus, the term, “enterprise of a Contracting State”, cannot apply to P: see the Art. 3(1)(d) definition.

4. Thus, the term, “enterprise of a Contracting State”, applies individually to ACO and BCO.

5. As Art. 7(1) is framed in terms of an enterprise of a Contracting State, the PE definition in Art. 5 (including Art. 5(3)) must be applied individually to ACO and BCO.

Scenario K (3/5)


Commentary to Art. 5(3) of OECD Model

Paragraph 19.1 :

“In the case of fiscally transparent partnerships, the twelve month test is applied at the level of the partnership as concerns its own activities. If the period of time spent on the site by the partners and the employees of the partnership exceeds twelve month, the enterprise carried on by the partnership will therefore be considered to have a permanent establishment. Each partner will thus be considered to have permanent establishment for purposes of the taxation of his share of the business profits derived by the partnership regardless of the time spent by himself on the site.”

OECD Partnerships Report

OECD Partnerships Report on Example 11:

“81. In this example, the Committee concluded that the period of time spent by the two partners should be aggregated at the partnership level with the result that the 12 month limit of paragraph 3 of Article 5 is exceeded. The enterprise carried on by the partnership will therefore be considered to have a permanent establishment in State S for the purposes of the taxation of their share of the business profits derived by the partnership from State S. This conclusion would not hold good if the relationship between A and B constituted merely a joint venture or consortium rather than a partnership.”

Scenario K (4/5)


Comments:

1. Prima facie, there is a conflict between:

(i) the fact that Art. 7(1) applies to each partner, and not to the partnership – for the reason that the partnership is not a resident of a Contracting State, and thus cannot be an “enterprise of a

Contracting State”; and

(ii) the view of the OECD (as shown in the OECD Commentary and the Partnerships Report) that the existence of a PE is determined at the level of the partnership.

2. The OECD resolves this conflict by a two stage attribution process. The first stage of the attribution is to attribute, from the partners to the partnership, the activities performed by the partners. If the consequence of the first stage is that the partnership is considered to have a PE, then the second stage of the attribution is to attribute that PE status, from the partnership to the partners.

The first stage of attribution can be seen in the second sentence of paragraph 19.1 of the OECD Commentary:

“If the period of time spent on the site by the partners and the employees of the partnership exceeds twelve month, the enterprise carried on by the partnership will therefore be considered to have a permanent establishment.”

The second stage of attribution can be the seen in the third sentence of paragraph 19.1 of the OECD Commentary:

“Each partner will thus be considered to have a permanent establishment for purposes of the taxation of his share of the business profits derived by the partnership regardless of the time spent by himself on the site.”

Scenario K (5/5)


ACO BCO

Country R tax



Transparent

P

***************************************************************

Country R

Country P

Loan

x% y%Interest


• P carries on a business through a PE in Country P.

• Both Country P and Country R treat P as a transparent entity for tax purposes.

• ACO makes an interest-bearing loan to P.

• Country P recognises loans between partners and partnerships under its domestic tax law. Country P allows P a tax deduction for the interest.

• Country R does not recognise loans between partners and partnerships under its domestic tax law.

Question:After applying the Country R/Country P treaty, what should be the tax treatment in each country in respect of the interest income received by ACO?

Scenario L (1/2)


ACO BCO

Country R tax



Transparent

P

***************************************************************

Country R

Country P

Loan

x% y%Interest


Country P tax treatment of the interest income received by ACO

Under the Country P tax law, the interest and loan are both recognised. Thus, from Country P’s perspective, it would be entitled to impose tax on the interest income, with a limitation of 10% of the gross amount of interest: Art. 11(2). Note that the Country P tax which is levied on the interest income is levied, from Country P’s perspective, in accordance with Art. 11(2), and not Art. 7(1).

Country R tax treatment of the interest income received by ACO

If the treaty has Art. 23A : Art. 23A(2) would require Country R to give a credit for the Country P tax on the interest.

If the treaty has Art. 23B : Art. 23B(1) would require Country R to give a credit for the Country P tax on the interest.

Scenario L (2/2)


ACO BCO

Country R tax



Transparent

P

***************************************************************

Country R

Country P

Loan

x% y%Interest


• P carries on a business through a PE in Country P.

• Both Country P and Country R treat P as a transparent entity for tax purposes.

• ACO makes an interest-bearing loan to P.

• Country P does not recognise loans between partners and partnerships under its domestic tax law.

• Country R recognises loans between partners and partnerships; under its domestic tax law, Country R would levy tax on ACO’s interest income.

Question:After applying the Country R/Country P treaty, what should be the tax treatment in each country in respect of the interest income received by ACO?

Scenario M (1/2)


ACO BCO

Country R tax



Transparent

P

***************************************************************

Country R

Country P

Loan

x% y%Interest


Country P tax treatment of the interest income received by ACO

Under the Country P tax law, theinterest and loan are not recognised. Thus, from Country P’s perspective:

• There is no flow of interest to which Art. 11 could apply; and

• The “interest” is part of the profits attributable to the PE, which Country P may tax under Art. 7(1).

Country R tax treatment of the interest income received by ACO

• If the treaty has Art. 23A :Art. 23A(1) would require Country R to exempt the full amount of the profits attributable to the PE, which amount would include the interest income.

• If the treaty has Art. 23B:Art. 23B(1) would require Country R to give a credit for the Country P tax on the profits attributable to the PE (the amount of those profits would include the interest income).

Scenario M (2/2)


Source (but no PE) in Country R

BCO

Country R tax


ACO


Taxable entity

Office in Country P

y%

Country P

x%

Country R

***************************************************************

• ACO is resident in Country P.

• BCO is resident in Country R.



• P has an office in Country P – P may therefore be considered to have a PE in Country P.

• P derives royalty income from Country R, but the royalty income is not attributable to a PE in Country R.


Scenario N (1/2)


Source (but no PE) in Country R

BCO

Country R tax


ACO


Taxable entity

Office in Country P

y%

Country P

x%

Country R

***************************************************************


• Prima facie, the conclusion would appear to be that P can claim treaty benefits (P would be a resident of Country P), and that accordingly Art. 12 would exempt P from any Country R tax on the royalties.

• The difficulty with that conclusion is that BCO is a resident of Country R and the relevant income is derived from a source in Country R: can the Country P/Country R treaty be used to prevent Country R from levying tax on its own resident in respect of income derived from sources in Country R?

• OECD Commentary on Art. 1:

“6.1 .. Where a partnership is treated as a resident of a Contracting State, the provisions of the Convention that restrict the other Contracting State’s right to tax the partnership on its income do not apply to restrict that other State’s right to tax the partners who are its own residents on their share of the income of the partnership. Some states may wish to include in their conventions a provision that expressly confirms a Contracting State’s right to tax resident partners on their share of the income of a partnership that is treated as a resident of the other State.”

Thus, in accordance with the OECD Commentary, the Art. 12 exemption would not apply to the extent of BCO’s percentage interest in the royalty income derived by P.

Scenario N (2/2)

√/X


***************************************************************

Source (but no PE) in Country P


Taxable entity

Country R tax


ACO BCO

Country R

Country PP

Royalties

x% y%




• P derives royalty income from Country P, but the royalty income is not attributable to a PE in Country P.


Scenario O (1/3)


***************************************************************



Taxable entity

Country R tax


ACO BCO

Country R

Country PP

Royalties

x% y%


• P cannot claim under the Country P/ Country R treaty: P would be considered to be a resident of Country P, but the royalties are derived from a source in Country P. Thus, none of the “operative” articles in the Country P/Country R treaty would apply to limit Country P’s taxing rights in respect of P.

X

Scenario 0 (2/3)


***************************************************************



Taxable entity

Country R tax


ACO BCO

Country R

Country PP

Royalties

x% y%

• However, can ACO and BCO claim exemption from Country P tax, under Art. 12 of the Country P/Country R treaty?

Note the following in the OECD Commentary on Art. 1:

“6.4 Where, as described in paragraph 6.2, income has ‘flowed through’ a transparent partnership to the partners who are liable to tax on that income in the State of their residence, then the income is appropriately viewed as ‘paid’ to the partners since it is to them and not to the partnership that the income is allocated for purposes of determining their tax liability in their State of residence. Hence the partners, in these circumstances, satisfy the condition, imposed in several Articles, that the income concerned is ‘paid to a resident of the other Contracting State’. Similarly the requirement, imposed by some other Articles, that income or gains are ‘derived by a resident of the other Contracting State’ is met in the circumstances described above. This interpretation avoids denying the benefits of tax Conventions to a partnership’s income on the basis that neither the partnership, because it is not a resident, nor the partners, because the income is not directly paid to them or derived by them, can claim the benefits of the Convention with respect to that income. Following from the principle discussed in paragraph 6.3, the conditions that the income be paid to, or derived by, a resident should be considered to be satisfied even where, as a matter of the domestic law of the State of source, the partnership would not be regarded as transparent for tax purposes, provided that the partnership is not actually considered as a resident of the State of source.” (emphasis added).

Scenario O (3/3)

X X


ACO BCO

Country R tax



Taxable entity

PE in Country P

P

Country R

***************************************************************

Country P

[Year 1: Taxable Profits = $1 million]

50% 50%Year 2 distribution: $300,000




• ACO’s percentage interest in Partnership P is 50%.

• P has a PE in Country P.

• In Year 1, P derives taxable profits of $1 million.

• P is liable for Country P corporate income tax of $400,000 (i.e. $1 million x 40%).

• In Year 2, P distributes to ACO its share of P’s after-tax profits – i.e. $300,000.

• Country P levies a dividend withholding tax of 10% (i.e. $30,000) on the cash distribution to ACO.

Question:After applying the Country P/Country R treaty, what should be the tax treatment in each country?

Scenario P (1/5)


ACO BCO

Country R tax



Taxable entity

PE in Country P

P

Country R

***************************************************************

Country P



This scenario corresponds to Example18 in the OECD Partnerships Report.

Country P tax treatment

• P would be subject to Country P tax on the $1 million of profits in Year 1. That tax liability would not be limited by the Country P/Country R treaty.

• Under its domestic tax law, Country P would levy a 10% dividend withholding tax on the $300,000 payment to ACO in Year 2. Under Art. 10(2)(a) of the Country P/Country R treaty, that tax would be limited to 5% - i.e. $15,000.

Country R tax treatment re BCO

• If the treaty has Art. 23A:

Art. 23A(1) would require Country R to exempt from tax BCO’s 50% share in the $1 million profit.

• If the treaty has Art. 23B:

Art. 23B(1) would require Country R to give a credit to BCO for its 50% share of the $400,000 tax paid by P.

Scenario P (2/5)


ACO BCO

Country R tax



Taxable entity

PE in Country P

P

Country R

***************************************************************

Country P



Country R tax treatment of ACO

• If the treaty has Art. 23A:

Year 1

Art. 23A(1) would require Country R to exempt from tax ACO’s 50% share of the $1 million profit.

Year 2

Art. 23A(2) would require Country R to give a credit to ACO for the $15,000 dividend withholding tax levied by Country P. However, there would be no Country R tax against which to claim the credit - see discussion below.

• If the treaty has Art. 23B:

Year 1

Art. 23B(1) would require Country R to give a credit to ACO for its 50% share of the $400,000 tax paid by P.

Year 2

Art. 23B(2) would require Country R to give a credit to ACO for the $15,000 dividend withholding tax levied by Country P. However, there would be no Country R tax against which to claim the credit – see discussion below.

Scenario P (3/5)



The analysis of this example in the OECD Partnerships Report is as follows:

“134. In this example, the conflict in income allocation that results from the different treatment of partnerships in States P and R raises the following various difficulties with respect to the elimination of double taxation by State R:

- the fact that State P taxes two different events (the earning of the profits and their distribution) while State R only taxes one event (the earning of the profits);

- the timing mismatch that results from the fact that State P taxes the distribution in year 2 but State R imposes its tax in year 1;

- the fact that the State P tax which is levied when the profits are earned is paid by the partnership while the State R tax is levied on the partners.

135. The first difficulty relates to whether State R should provide credit for the tax levied by State P upon the distribution. This is an issue that concerns equally States applying the exemption method and States applying the credit method. If State R applies the exemption method, it must refrain from taxing the partnership’s business profits derived from State P in year 1 (it is, of course entitled to take the excluded income into account in determining the rate of tax on A’s remaining income pursuant to paragraph 3 of Article 23 A); if it is a credit State, it must give credit for State P’s tax levied on these profits in year 1. In both cases, however, the Convention theoretically requires that it should provide a credit for State’s P’s tax levied on the distribution against its tax on such a distribution (paragraph 2 of Article 23 A and paragraph 1 of Article 23 B).

Scenario P (4/5)



“136. Since, however, State R does not tax the distribution, there is no tax levied by State R against which to credit State P’s tax levied upon the distribution. While the Convention would allow State R to tax the profit distribution made in year 2, such taxation would be inconsistent with State R’s treatment of partnership and is therefore not allowed by its domestic law. Under that law, the income may be taxed (subject to any relief from double taxation) only in the year it was earned, i.e. year 1. The manner in which taxation rights allowed by a treaty are exercised is, of course, a matter of domestic law.

137. A clear distinction must be made between the generation of profits and the distribution of those profits. State R, if it is an exemption State, has to exempt from tax the generation of profits in year 1 and therefore is not permitted under the Convention to tax the profits when earned on the basis that Article 10 would allow them to be taxed when distributed. Similarly, however, State R (if it is credit State) should not be expected to credit the tax levied by State P upon distribution against its own tax levied upon generation.

138. Once it is agreed that State R does not levy tax on the distribution, the second difficulty, i.e. the timing mismatch, is no longer relevant. While timing mismatches frequently create problems for foreign tax credit purposes, which leads States to adopt rules allowing for the carry-back or carry-forward of foreign tax credits, the issue does not arise in this example since there is no double taxation of the distribution.

139 The third difficulty concerns only States that apply the credit method and relates to the fact that both States impose tax upon the same income, but on different taxpayers. The issue is therefore whether State R, which taxes partner A on his share in the partnership profits, is obliged, under the Convention, to give credit for the source tax that is levied in State P on partnership P, which State P treats as a separate taxable entity. The answer to that question must be affirmative. To the extent that State R flows-through the income of the partnership to the partners for the purpose of taxing them, it should be consistent and flow-through the tax paid by the partnership for the purposes of eliminating double taxation arising from its taxation of the partners. In other words, if the corporate status given to the partnership by State P is ignored for purposes of taxing the share in profits, it should likewise be ignored for purposes of giving access to the foreign tax credit.”

Scenario P (5/5)




– Background



– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A


Acceptance of OECD’s position

• Four OECD members (i.e. the Netherlands, France, Mexico and Portugal) have made Observations on that part of the Commentary to Art. 1 which relates to partnerships.

• Five OECD members (i.e. the Netherlands, France, Portugal, Germany and Switzerland) made Reservations on the OECD Partnerships Report.

• Five countries which are not members of the OECD (i.e. Brazil, Gabon, Ivory Coast, Morocco and Tunisia) have indicated an absence of full agreement with the Commentary in respect of partnerships.




– Background



– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A


2006 US Model

Art. 1 (6) :

“An item of income, profit or gain derived through an entity that is fiscally transparent under the laws of either Contracting State shall be consideredto be derived by a resident of a State to the extent that the item is treated for purposes of the taxation law of such Contracting State as the income, profit or gain of a resident.”

Art. 3 (1) :

“For the purposes of this Convention, unless the context otherwise requires :

a. the term ‘person’ includes an individual, an estate, a trust, a partnership, a company, and any other body of persons;

b. the term ‘company’ means any body corporate or any entity that is treated as a body corporate for tax purposes according to the laws of the state in which it is organized;

…….”




– Background



– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A


Background

• The US “check the box” (CTB) rules were introduced into US tax law in 1997. Prior to this time, classification of foreign entities was done according to the “Kintner” regulations.

• The CTB rules, unless the entity is a “per se” corporation, permit a classification of an entity as transparent or non-transparent (for US tax purposes). With the CTB rules, an entity can easily be classified differently in the US and other countries.


“Hybrid Entities”

USCO

US treatment: Disregarded entity (“tax nothing”)

US

Foreign Country

XCO

USCO 1

US treatment: Partnership

US

Foreign Country

XCO

USCO 2

“ Hybrid Entity” :

• US (outbound) tax treatment : Transparent

• Foreign Country tax treatment : Non-transparent (e.g. company)


“Reverse Hybrid Entities”

USCO 1

US treatment: Corporation

US

Foreign Country

XCO

USCO 2

“ Reverse Hybrid Entity” :

• US (outbound) tax treatment : Non-transparent

• Foreign Country tax treatment : Transparent (e.g. partnership)


US LLC as a Hybrid Entity : Situation 1

• Can treaty benefits be claimed under the US / Country S treaty ?

• US Model : yes (Art. 1(6))

• OECD Model : probably no.

– US LLC not “resident” in US (because not “liable to tax” in US) : Art. 4(1).

– USCO does not derive the relevant income.

USCO

US

Country S

USLLC

Income fromsource inCountry S


US LLC as a Hybrid Entity : Situation 2


• US Model : no.

• OECD Model : no.

Non-USCo.

Offshore

Country S


USLLC


Foreign Partnership as a Reverse Hybrid Entity


• US Model : no.

• OECD Model : no.

USCO 1

US

Country S

XCO

USCO 2





– Background



– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A


Trusts

One or more beneficiaries

Country S

Trustee


• Variables :

– Fixed trust vs. discretionary trust

– Trustee and all beneficiaries resident in same country vs. multiple countries

– Residence country tax treatment of trust income : taxation of trustee vs. beneficiaries

• OECD Model : Should principles in Partnerships Report apply ?

• US Model

Offshore




– Background



– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A


REITs (Real Estate Investment Trusts)

• 30 October 2007 : OECD released public discussion draft on REITs and treaties.

• REITs take different legal forms – for example :

– US, Japan : Corporation

– Singapore : Trust

• However, one key characteristic is that 100% (or close to 100%) of a REIT’s profits are usually distributed to its members / owners – and consequently the REIT is not subject to tax in its “home” country (due to specific exemption).


REITs : High Level of Distribution

Treaty issues

• REIT = “liable to tax” per Art. 4(1) ? Yes

• Who can claim treaty benefits on income derived by REIT from foreign countries ? The REIT or the members / owners ?

• REIT distributions : Art. 6 (income from immovable property) or Art. 10 (dividends) ?

Members / owners of

REIT

REIT


DistributionsMembership/ ownership interests

Not taxable, if sufficient distributions are paid




– Background



– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A


CIVs (Collective Investment Vehicles)

• Early 2007: OECD creates an “Informal Consultative Group” (ICG) to study and make recommendations regarding the taxation of CIVs and other investments held through custodians and nominees.

• Proposed timetable:

– May 2007: First meeting of ICG

– October 2007, March 2008, October 2008: Subsequent meetings of ICG

– October 2008: ICG’s final report


CIVs : Treaty Issues

Treaty issues

• Is a CIV a “person”?

• Is a CIV that is a “person” a “resident of a Contracting State”?

• Is the CIV the “beneficial owner” of income?

• Are the investors in the CIV the “beneficial owners” of the CIV’s income?

• How does the residence country provide double tax relief?

Numeroussmall

investors

CIV


DistributionsMembership/ ownership interests

Legal form: Company, trust, joint ownership vehicle (eg fonds communs de placemen), contractual custodianship




– Background



– Key principles

– Examples


– US Model



– Trusts

– REITs

– CIVs

• Q & A

This presentation of slides is intended as a general guide only, and the application of its contents to specific situations will depend on the particular circumstances involved. Accordingly, readers should seek appropriate professional advice regarding any particular problems that they encounter, and this presentation should not be relied on as a substitute for this advice. While all reasonable attempts have been made to ensure that the information contained in this presentation is accurate, Deloitte Touche Tohmatsu and its member firms accept no responsibility for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person that relies on it.

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beneficial ownership: treaty entitlement, including transparent entities oecd – ifa tax...

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