BONUS CONTENT: Treaty-Shopping

This is a bonus post for paying subscribers. Sign up here for an Emperor Subscription to get full access, including past interviews and extra content.

I’ve often called double tax treaties the arteries of the global tax system. Like real arteries, there needs to be some way to regulate what gets in or out–or it’ll get messy and dangerous real quick.

One of those regulatory systems in the treaty network are the rules against “treaty-shopping,” which have existed for decades and were made part of the Organization for Economic Cooperation and Development’s official framework in 2015. Part of the Action Plan for Base Erosion and Profit Shifting, the recommendations call for a rule to ensure that only true residents take advantage of the treaties.

That’s one simple idea, but there are a few different ways to go about it, that sometimes come into conflict.

The main point of treaty-shopping is for the taxpayer to avoid the withholding taxes that countries will impose on outbound payments such as royalties or dividends, absent a treaty agreement to reduce them. Countries generally want their taxpayers to do business based on the arm’s-length standard, with treaty protections against tax disputes and without simple withholding taxes taking a large chunk out of every crossborder payment. But they can’t afford to give this treatment to everyone, and have a “treaty with the world,” as it’s sometimes been called. Those withholding taxes are their tax base’s protection against havens and erosion. So a system to ensure that a tax treaty only involve taxpayers from that country is needed.

Treaty-shopping combines two of the more interesting areas of international tax law–residency and anti-abuse rules. Both seem simple at first blush but can get very complex, and sometimes very subjective, the more you drill down into them.

The OECD, in its 2015 report, lays out two different ways to prevent treaty-shopping–the principal purpose test, and the limitation on benefits rule. The contrast between the two rules will be familiar to regular readers, as well as anyone who’s been following global tax debates these past few years.

The principal purpose test is a broad mandate for a tax authority to divine the taxpayer’s true intentions behind a given structure or payment, and to adjust or possibly recharacterize it entirely. In that sense, it’s similar to a general anti-avoidance rule or the U.S. economic substance doctrine. The test asks whether “it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining [a treaty] benefit was one of the principal purposes of any arrangement or transaction.” If so, it nullifies the benefit, unless it is expressly authorized elsewhere in the treaty.

In contrast to the intentions-based principal purpose test, the limitation on benefits rule is a much narrower, more objective set of criteria to determine the residency of a company in a transaction, and the true beneficiary of a transaction. It looks into factors such as the employee’s place of business and where its shares are bought and sold. It can make determinations which are less susceptible to questioning–but also miss other cases entirely.

With the endorsement of the OECD, the principal purpose test has grown in use around the world, although because this is a treaty rule countries cannot necessarily add it to pre-existing agreements unless both sides agree. This new ubiquity has led to criticism from some practitioners, who claim its ambiguous nature gives unprincipled tax authorities free rein to tear up tax structures they don’t like.

After all, tax treaties are supposed to set up a tax-optimized way for crossborder business. In that sense, every transaction under the treaty is tax-motivated. How does a tax authority determine a transaction’s purpose, let alone a principal purpose? (There’s also the puzzling inclusion of “one of the” in the clause, implying that a transaction may have multiple principal purposes.)

“No one really knows what the PPT means,” wrote the inimitable Lee Sheppard in Tax Notes.

A large outlier to this new trend is, as usual, the United States. (Though the U.S. was an early adopter of anti-treaty-shopping rules in the first place.) The U.S. model treaty includes a lengthy limitations on benefits section, and the U.S. remains a strong advocate for the rule and against the principal purpose test.

The U.S. rule includes several factors, including not only the place of management and control of the entity but whether it has an active trade or business in the jurisdiction and, if it has publicly traded shares, if the majority of them are traded or held there. (Not all of these factor necessarily apply in a single case--conditions determine which tests to use.)

It’s ironic that the U.S. LOB provision includes a test for management and control, as the U.S. is one of the few countries whose domestic laws only look to incorporation to determine residency, not the location of actual management. But these rules exist domestic laws, in a way–they apply in cases where the domestic laws come up short, or don’t apply at all.

Critics of the limitation on benefits rule, especially as used by the U.S., claim that while it may apply on a more objective basis, it can also be avoided and planned around. They note the corporate inversions and other problematic structures which took advantage of the U.S. treaty with Ireland. In many of those cases the transactions would use Ireland as a gateway to another jurisdiction.

Again, this is the seemingly eternal debate in international tax policy–do you go with flexible but unreliable principles or hard-and-fast but cumbersome formulas? Or a bit of both? The OECD BEPS “minimum standards” state that either an LOB or PPT rule can be used, but the LOB must be supplemented with at least an anti-conduit financing provision.

Like all international rules, the anti-treaty-shopping rules will continue to come under strain as the global economy evolves. In particular, it will be interesting to see if the rise of remote work and the cloud begin to chip away at rules for locating management and control, both in domestic laws and treaties. It’s not absurd to imagine that in a decade’s time, entirely online companies with no central headquarters and managers scattered in dozens of countries will be among the world’s largest corporations. Imagine the treaty-shopping opportunities there.

And if the digital economy makes the national borders more and more porous, it may start to call into question the whole idea of making country-specific bilateral treaties the thoroughfares of the system.

Contact the author at amparkerdc@gmail.com.