OECD’s Base Erosion and Profit Shifting (BEPS) Project is proceeding at a break-neck speed. Hardly a day passes without a new discussion paper being put in the public domain for comments and inputs. And before, one can properly digest the proposals and analyse the same, out comes another discussion paper.

There are 15 points for action in terms of the BEPS action plan. There is of course a time line given. It is also important that decisions are not unduly delayed as otherwise governments affected by base erosion will take unilateral measures. An important point however is whether decisions are being taken after proper deliberation or are being rammed through without all the parties understanding the implications of the various proposals. This is particularly true in the case of the developing countries that are participating in the OECD work for the first time apparently on an equal footing. They may not have sufficient personnel to properly analyze the issues and their implications on the domestic tax systems in such a hurry. To give credit to the OECD, it also makes available the comments on the discussion drafts that are initially drafted by the CTPA secretariat after deliberations in various working groups. However, if one goes through the comments received, these are mostly from the law firms or accountancy firms representing interests of the MNCs. Of late, civil society groups are also participating but one hardly finds comments from the academia in these instantaneous reactions.

When the BEPS project was conceived, it was expected that we would have a brand new international tax order taking a balanced view of the interests of the developed and the developing countries. The way the project is going so far however raises doubts about such an outcome. Hurried decisions taken without appropriate consideration of all the issues cannot be imposed on everybody in the name of ‘international consensus’. BRICS along with Indonesia and Saudi Arabia are now part of the decision-making process and have the moral obligation to represent the viewpoints of the developing countries and in many areas the interests of developing and developed countries do not coincide.

As for the proposals, in the month of March itself four discussion drafts have already been released. Two were released on the 19th on the issue of neutralizing the effect of hybrid mismatch; one was released on the 15th on the very important topic of preventing treaty abuse. And as I write this piece, on the 24th another draft has been released on the digital economy.

Considering the fact that treaty abuse is a burning issue in India, let us have a look in some details at the proposals in this regard.

Realizing that the interaction between the treaty provisions and the domestic law systems of various countries create opportunities for tax avoidance particularly through the interposition of conduits controlled from third countries, the BEPS Action Plan recognised that there is a need to modify the existing domestic and international taxation rules.

The Action Plan considered that treaty abuse is the most important source of base erosion and profit shifting and ‘[t]ight treaty anti-abuse clauses coupled with the exercise of taxing rights under domestic laws will contribute to restore source taxation in a number of cases.’ Therefore action point 6 stated as follows: “Develop model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances. Work will also be done to clarify that tax treaties are not intended to be used to generate double non-taxation and to identify the tax policy considerations that, in general, countries should consider before deciding to enter into a tax treaty with another country. The work will be co-ordinated with the work on hybrids.”

In the discussion draft now put out, the main area of treaty abuse addressed is also treaty shopping. Unlike the Indian Supreme Court, OECD does consider treaty shopping as an unmitigated evil and suggests a mind- boggling draft of measures to tackle the same. As for the report, the three areas in which the work is divided are:

A. Recommendations regarding design of treaty provisions and of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances.

B. Clarification that tax treaties are not intended to be used to generate double non-taxation.

C. Identification of the tax policy considerations that countries should consider before deciding to enter into a tax treaty with another country.

While the suggestions relating to the first two areas are generally welcome, there are problems with the third area, as we shall discuss subsequently.

As for treaty based solutions, the proposal is to have a limitation on benefits (LOB) article, a treaty GAAR and some targeted anti abuse rules (TAAR). These are described below.

Treaty LOB:

In the area of treaty-based solution, OECD suggests a comprehensive American style LOB. In fact, the current OECD commentary, in the context of Article1 does suggest such an article. Although not entirely consistent, some of India’s treaties also contain such a provision. [For a description of the LOB provision in the India-USA tax treaty, see Apology of an LOB]

Derivative benefit test:

The draft also includes a discussion about the possible inclusion of a ‘derivative benefit’ test if certain further conditions are satisfied. The draft has invited comments about the desirability of having such a provision pointing out that it may lead to base erosion in some cases.

According to the technical explanation of the US Department of treasury explaining the protocol to the US- Germany treaty that contains a similar provision, in general, a derivative benefits test entitles the resident of a Contracting State to treaty benefits if the owner of the resident would have been entitled to the same benefit had the income in question flowed directly to that owner. In respect of dividends, interest etc., there is also a base erosion test to be satisfied.

The derivative benefit exemption in the US LOB clause is being incorporated in US treaties with countries belonging to European Union and NAFTA region to make an exception to the rule to prevent third country residents to benefit from a particular tax treaty. The reason for the same is the freedom of establishment principle of the EU that allows EU member countries to establish entities and do business across the EU. [Article 52 of the EC treaty]

However, the short point is that it is a hellishly complicated provision. Why the OECD wants to inflict the rest of the world with such complicated America-centric and EU-centric solutions that may again result in base erosion is not comprehensible particularly when the OECD wants to adorn the mantle of the world’s sole arbiter in the matter of international taxation. The derivative benefit exemption can hardly be of any use for the developing countries.

Treaty GAAR:

Listed companies are out of the ambit of the proposed LOB. However, as pointed out in the discussion draft, assuming that the public company is a bank that enters into a conduit financing arrangement with a resident of a third country who would not have benefited from the particular treaty, such a structure would not be caught by the LOB provision but is nevertheless a treaty shopping transaction. In order to cover such cases, the draft suggests the incorporation over and above the LOB provision a catchall provision in a separate article as follows:

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

Note the use of the expression ‘one of the main purposes’. Explaining the same it is pointed out that obtaining the benefit under a tax convention need not be the sole or dominant purpose of a particular arrangement or transaction. It is sufficient that at least one of the main purposes was to obtain the benefit. For example, a person may sell a property for various reasons, but if before the sale, that person becomes a resident of one of the Contracting States and one of the main purposes for doing so is to obtain a benefit under a tax convention, the provision could apply notwithstanding the fact that there may also be other main purposes for changing the residence, such as facilitating the sale of the property or the re-investment of the proceeds of the alienation. (The contrast with Shome Committee report on GAAR is obvious). The discussion draft also gives a few examples of cases that can be considered to determine whether one of the man purposes was for the purpose of obtaining treaty benefits or not.

Treaty TAAR:

Residence rule:

Apart from a treaty LOB and a treaty GAAR, there are proposals for some targeted anti- abuse measures also to be incorporated in the treaties. Most important of these is the proposed change in the tie-breaker rule in treaties in determining corporate residence based on the place of effective management (POEM) test. There is realization that such a rule may also lead to tax base erosion.

The double-Irish Dutch sandwich made famous by Google and Company is obviously the target although it is not specifically mentioned as such in the report. This technique, amongst other things, takes advantage of the fact that in Ireland a company is not considered resident if the place of effective management (POEM) is somewhere else. That’s why companies registered in Ireland are shown to be managed from Bermuda and other havens and no tax is paid anywhere. The OECD therefore proposes to change the rule that gives prominence to POEM and wants to replace the same by a competent authority process. If a company is a resident of two Contracting States, it would be denied the treaty benefits unless the Competent Authorities agree otherwise.

While we do have a few treaties containing somewhat similar provision, the workload of the Competent Authority will obviously increase if in each case it is to be decided beforehand about the residence of a company.

Triangular cases:

When the residence country follows the exemption model of relieving double taxation, sometimes the MNC group would establish a PE in a third low tax country and make other group entities pay royalty / interest to the PE by transferring intellectual property/ debt to the PE since the income attributable to the PE would then be taxed at a low rate. . To counter such practice, the draft proposes that treaty benefits should be denied if the PE profits are subject to a combined effective tax rate in the residence and the PE state of less than 60% of the general rate applicable in the Residence State. There are exceptions provided in case of royalties for intangible properties developed by the PE and if income derived from the source State is connected with the active conduct of a trade or business in the third State.

Change in the Preamble: Prevention of double non-taxation:-

The objective of a tax treaty is to prevent double taxation between the residents of the two Contracting Sates. However, the actual operation of the treaties is such that in many situations there is double non-taxation. To prevent such a situation from arising, the proposal is to change the preamble of the treaty itself to clarify the purpose. This is obviously for the guidance of the Courts that often get carried away and resort to very liberal interpretation conferring treaty benefits in obviously undeserving cases.

It has been proposed to change the preamble which will state as follows:

“(State A) and (State B), [d]esiring to further develop their economic relationship and to enhance their cooperation in tax matters,

Intending to conclude a Convention for the elimination of double taxation with respect to taxes on income and on capital without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty shopping arrangements aimed at obtaining reliefs provided in this Convention for the indirect benefit of residents of third States)[h]ave agreed as follows:”

Other treaty based proposals:

There are further treaty based proposals against splitting up of construction contracts to avoid the time threshold of a PE, transactions intended to avoid dividend characterization. It is also proposed that lower withholding rate of a treaty in respect of dividends will be applicable only if there is a holding for a minimum period. This is like the anti- dividend stripping provision in the domestic context. The draft has asked for views on the appropriate period of time. There is also a proposal to amend Article 13 (4) to prevent circumvention of Article 13(4) relating to capital gains.

Domestic law solution:

Apart from treaty-based proposals there are also proposals based on the domestic law and considerations of CFC, thin cap rules etc. Some of the measures suggested in the context of the hybrid mismatch will also be relevant. These are not being discussed for the time being. However, there is one other proposal we mentioned at the beginning that needs to be looked at seriously.

Tax policy:

The discussion draft rightly says that countries should evaluate various tax policy considerations before entering into tax treaties with a potential treaty partner as also for revisiting existing treaties. These are as follows:

• Considering the actual or potential volume of trade and investment between the countries, whether there is need for a treaty when in fact double taxation can be relieved by domestic tax system.

• When a State levies no or low income taxes, in the absence of risk of double taxation, whether there is any need for a tax treaty. In the Indian context, why we have treaties with Mauritius, Cyprus, Singapore and why we are proposing to have a treaty with Hong Kong is beyond comprehension.

• States should consider the potential of double non-taxation as a result of the combination of domestic and treaty laws.

• States should also consider the extent of withholding tax in the source state- whether the same is commensurate with residence country tax on the same source of income or not.

• Ability of the State to effectively exchange information and to provide providing assistance in collection of taxes; and importantly:

• “[f]urther tax considerations that should be taken into account when considering entering into a tax treaty include the various features of tax treaties that encourage and foster economic ties between countries, such as the protection from discriminatory tax treatment of foreign investment that is offered by the non-discrimination rules of Article 24 the greater certainty of tax treatment for taxpayers who are entitled to benefit from the treaty and the fact that tax treaties provide, through the mutual agreement procedure, together with the possibility for Contracting States of moving to arbitration, a mechanism for the resolution of cross-border tax disputes.”

According to the Discussion draft, these policy considerations are important not only for entering into tax treaties but also for considering whether a State should seek to modify or replace an existing treaty or in the extreme terminate a tax treaty.

While most of these are very valid considerations, the insistence of the OECD on the compulsory arbitration clause in a tax treaty is unjustified, particularly from a developing country perspective. The implication of the recommendation is that unless a State agrees to have a compulsory arbitration clause, there should be no treaty. Even in the case of existing treaties, there will be a threat of cancellation of a treaty if a State is unwilling to incorporate such a provision.

At the instance of the USA, OECD is pressing hard for a compulsory arbitration clause in the Mutual Agreement Procedure(MAP). There was no consensus at the United Nations on this aspect with developing countries objecting to the proposal. The latest effort in the BEPS context has also to be resisted by developing countries. India should be particularly wary of a compulsory arbitration clause in the light of its experience in the context of BIPA.