With a view to curb tax avoidance, BEPS Action Plan 6 imposes minimum standards to prevent grant of treaty benefits obtained by circumvention of either the treaty itself (e.g. treaty shopping through conduit finance arrangements) or of domestic tax legislations. Under the MLI provisions, Article 7 (which deals with prevention of treaty abuse and is applicable as a minimum standard), prescribes Principal Purpose Test (‘PPT’) as one of the measures to prevent treaty abuse.

In this regard, Vrinda Bagaria (Advocate) analyses the interplay of domestic general anti-avoidance rules (‘GAAR’) and treaty GAAR or the Principal Purpose Test (‘PPT’). Illustrating by way of an example on perpetual securities, the author explains that uncertainties in application and conflicting results of domestic GAAR, often render it unsuitable for prevention of treaty abuse in international context whereas “PPT ensures a consistent approach to meet common objectives of both states, in accordance with the treaty provisions.” Similarly, the author elucidates on the interplay of LOB (Limitation of Benefit) and PPT. The author also discusses about transactions which might lead to overlap of PPT and domestic GAAR. While signing off the author states that, “...while the MLI reveals prospects for ‘cooperative multilateral solution’, differing approaches adopted by states and the current stream of unilateral measures in digital taxation indicate that the road to multilateralism is far.”

“Interplay of Domestic GAAR and PPT – An Overview”

Introduction: BEPS Action Plan 6

1.1 The international tax system is primarily based on territorial regime (source-based) or world-wide regime (residence-based) of taxation. Double tax agreements (‘DTAs’) are adopted to allocate taxation rights between two countries on cross-border income and prevent double taxation.[1] Nonetheless, absence of uniform tax laws between individual countries provide multinational corporations with opportunities to avoid tax liabilities through treaty abuse measures, eventually causing double non-taxation.

1.2 ‘BEPS Action Plan 6 for Prevention of Treaty Abuse’ (‘AP6’) imposes minimum standards to prevent grant of treaty benefits obtained by circumvention of either the treaty itself (e.g. treaty shopping through conduit finance arrangements) or of domestic tax legislations. This article analyses the interplay of domestic general anti-avoidance rules (‘GAAR’) and treaty GAAR or the Principal Purpose Test (‘PPT’)

1.3 Under AP6, jurisdictions[2] are required to amend their DTAs (i) to include an express statement on non-taxation; and (ii) adopt one of the three methods for addressing treaty abuse:[3]

1.3.1 The PPT together with a simplified or detailed version of Limitation of Benefit rule (‘LOB’);

1.3.2 The PPT alone;

1.3.3 A detailed version of the LOB, supplemented by a mechanism such as a treaty rule, domestic anti-avoidance rule or judicial doctrines.

1.4 Article 29 (‘Entitlement of Benefits’) of the 2017 Model Tax Convention incorporates the LOB and PPT rules.[4] LOB (paras 1-7) is a specific anti-avoidance rule (‘SAAR’) that limits treaty benefits to ‘residents of Contracting States’[5] who are ‘qualified person’[6]. Conversely, PPT[7] is a general anti- avoidance rule that prevents granting of treaty benefits subject to following conditions:

1.2.1 It can reasonably be concluded from the facts and circumstances that ‘one of the principal purposes of any arrangement or transaction’ was to obtain tax benefit; and

1.4.2 Such benefit is not in accordance with the ‘object and purpose’ of relevant treaty provisions.

1. 5 A dichotomy arises as OECD provides jurisdictions the flexibility to adopt domestic GAAR for prevention of treaty abuse.[8] Consequently, jurisdictions have exercised their option to adopt either PPT[9] alone or LOB along with domestic anti-avoidance rules. The reservation clause[10] raises further obscurity since countries with provisions similar to the LOB and/or PPT in their DTAs choose to maintain status quo.[11] Such differing approach questions the effectiveness of BEPS in attaining an outcome of uniform tax reforms. To ensure a more uniform approach, jurisdictions should adopt both PPT and LOB to effectively prevent treaty abuse and refrain from encouraging the application of domestic GAAR to treaty provisions.Moreover, in event of an overlap between domestic GAAR and PPT (treaty GAAR), PPT must prevail to give effect to object and purpose of treaty provisions. The below case-studies analyze the application of the domestic GAAR vis-à-vis the treaty provisions under AP6 to stress that in event of a conflict, treaty should prevail.

2. Domestic GAAR vis-à-vis PPT

2.1 Diagram 1 represents a transaction between XCO (resident of State X) and YCO (resident of State Y) where XCO raises finance by issuing perpetual securities (‘perps’) to YCO. Both States have a X-Y DTA which:

2.1.1 Exempts withholding tax (‘WHT’) on interest in source state; and

2.1.2 Provides participatory exemption on dividend received in resident state.

2.2 One main purpose of XCO to issue ‘perps’ is obtaining tax benefit pursuant to treatment of ‘perps’ as debt in State X and equity in State Y. Accordingly, payment made against ‘perps’ is treated as interest and escapes WHT in State X. Concurrently, it is treated as dividend in State Y and receives participatory exemption, resulting in double non-taxation.

Diagram 1

2.3 Issues that arise prima facie in application of domestic GAAR are:

2. 3.1 Which country’s GAAR should be invoked (since both states suffered tax loss);

2.3.2 Are there any overt acts to ascertain the objective intention of transaction was to obtain tax benefit;

2.3.3.Does transaction lack economic substance;

2.3.4 What will be the outcome if State X assesses application of GAAR against ‘main purpose’ test and State Y applies ‘merely incidental purpose’ test?

2.4 The above issues indicate lack of consensus between countries; uncertainties in application and conflicting results that entail application of domestic GAAR, rendering it unsuitable for prevention of treaty abuse in international context.

2.5 Conversely, if PPT is applied, the transaction will be struck down because a main purpose of the arrangement is to obtain tax benefit in a manner unintended by treaty provisions. In essence, PPT ensures a consistent approach to meet common objectives of both states, in accordance with the treaty provisions.

3. THE LOB and PPT

3.1 The LOB evaluates the nature of entities to ascertain their entitlement to treaty benefits. Whereas, PPT looks at the purpose with which the arrangement was executed. If the taxpayer is a ‘qualified person’, LOB will not operate. Instead, PPT may be applied to ascertain the nature of arrangement.  Essentially, PPT supplements LOB in cases which so demand. Diagrams 2 and 3 below represent two similar transactions[12] that entail distinct consequences.

3.2 Diagram 2 represents a transaction where XCO (resident of State X) wants to buy shares in YCO (resident of State Y). In absence of a DTA between States X and Y, dividend paid against shares will be subject to WHT @ 30% in State Y (source state). To avoid this liability, XCO incorporates a wholly-owned subsidiary (WOS) ‘ZCO’ in State Z to buy shares in YCO. States Z and Y have a DTA under which dividend is taxable at reduced rate of 5% in State Y and receives participatory exemption in State Z (resident State). Accordingly, XCO obtains tax benefit under Y-Z DTA.

3.3 Assuming that Y-Z DTA adopted the PPT and simplified LOB, ZCO does not satisfy LOB. It is not a ‘qualified person’[13]. It is neither engaged in the active conduct of the business[14] nor fulfills the ‘derivative benefit’[15] test (as it is owned by XCO which is not an ‘equivalent beneficiary’[16]). Therefore, in this case LOB operates to deny treaty benefits to ZCO.

Diagram 2

3.4 In the preceding transaction, considering XCO had engaged a listed financial institution (‘qualified person’) in State Z (see Diagram 3), LOB will not apply. However, by virtue of the term ‘notwithstanding’, PPT will operate to deny XCO the tax benefit which it is not entitled to obtain under Y-Z DTA.

Diagram 3

3.5 Perhaps, an argument follows that adoption of PPT alone is sufficient to counter both transactions. Pertinently, however, LOB acts in limine as compared to PPT that involves a more intricate process. Hence, LOB ensures a prudent approach to repudiate transactions at the threshold and avoid unnecessary deliberations whilst PPT supplements LOB where it is inapplicable.

3.6 Therefore, both LOB and PPT should be adopted for prevention of treaty abuse, to the exclusion of domestic GAAR. Even so, in cases where PPT is not applicable, countries may apply domestic GAAR to prevent treaty abuse, causing an overlap between PPT and domestic GAAR.

4. Overlap between PPT and domestic GAAR[17]

4.1 An overlap occurs when situations that PPT does not entice are countered by domestic GAAR (or vice-versa). In such cases, PPT should prevail over domestic GAAR to meet the object and purpose of treaty provisions.

4.2 The principles of ‘pacta sunt servanda’ (art. 26) and ‘general rules of interpretation’ (art. 31) embodied in VCLT[18] form the basis of treaty interpretation. Art. 31(3) states that any subsequent ‘agreement’ or ‘practice which establishes an agreement’ between parties shall be taken into account for interpretation of treaties. Two arguments arise pursuant to this article:

4.2.1 Treaties that adopt the safeguard clause[19] permit a state to apply domestic GAAR;

4.2.2 If states have formerly applied domestic GAAR to prevent grant of treaty benefits otherwise in accordance with PPT (or vice-versa), there is an implied agreement between parties. Accordingly, application of domestic GAAR is appropriate.

4.3 Above arguments, although valid, do not conform to the principle of ‘pacta sunt servanda’ [read with art. 31(1)] that imposes on parties an over-riding obligation to perform a treaty in good faith such that the rights conferred upon the parties and the discretionary power inherent in such rights are exercised honestly, fairly and reasonably to meet the object and purpose of treaty.[20] Further, art. 31(1) gives precedence to ‘ordinary’ meaning of the terms of a treaty. Hence, if an arrangement conforms to the terms in a manner consistent with object and purpose of treaty, parties must not exercise their rights to invoke domestic GAAR.

4.4 To illustrate[21], Diagram 4 represents a transaction where an individual X (resident of State R) owns shares in BCorp (resident in State S). BCorp invests only in movable and immovable property. Consequently, shares owned by X derive 49% value from movable property and 51% from immovable property. X desires to sell his shares. However, under the R-S DTA, sale of shares that derive 50% or more value from immovable property is subject to capital gains tax in the state where immovable property is situated (State S). To avoid this liability, X infuses cash in BCorp. Accordingly, value of shares derived from immovable property falls below 50% and X sells the shares without payment of tax. In this case, X circumvents the treaty provisions with the purpose of avoiding tax liability. Assuming that R-S DTA has adopted the PPT, it will apply to prevent X from gaining tax benefit.

Diagram 4

4.5 In same transaction, assuming that R-S DTA had adopted art. 9(1) which imposes a requirement that shares have to be held for minimum period of 365 days[22] and X complies with the terms - is it treaty abuse? Art. 9(1) is a treaty SAAR and as X fulfilled its requirements, it will not be applicable. Moreover, as X is engaged in genuine economic activities in State S, compliance with SAAR effectively eliminates the element of artifice otherwise discernible in previous scenario. Question is will PPT apply? On basis of doctrine of ‘generalia specialibus non derogant’ and art. 31(1), it can be asserted that if SAAR is satisfied in a manner consistent with the object and purpose of treaty provisions, it shall continue to apply over treaty GAAR.[23]

4.6 Then, is it appropriate for State S to invoke domestic GAAR to negate the transaction? Ideally, once a transaction surpasses the treaty SAAR and PPT, domestic GAAR should not be invoked. Importantly, because it violates the principle of ‘pacta sunt servanda’ which makes a treaty binding on parties and imposes an obligation to act in good faith. Thus, application of domestic GAAR in such scenarios is incomprehensible and defeats the purpose of DTAs.

5. Conclusion

5.1 Tax avoidance measures are essentially adopted by those who can afford, to prejudice those who cannot. Anti-avoidance rules play a vital role at domestic and global level. It maintains symmetry by protecting state exchequer and ensuring distributive justice. Therefore it is important to ensure a more uniform approach in applicability of the anti-avoidance rules in the international context to eliminate the possible conflicts and obscurities that may ensue in unending litigation. This also brings to fore the issue that while the MLI reveals prospects for ‘cooperative multilateral solution’, differing approaches adopted by states and the current stream of unilateral measures in digital taxation indicate that the road to multilateralism is far.