S. 451Tax Avoidance involving Tax Treaties

S. 453I. Introduction

It is a privilege to be able to contribute these comments to a book in honour of Helmut Loukota. I first met Helmut Loukota in the late 1980s as a delegate to the OECD Working Party No. 1 and, over the last 15 years, I have been fortunate to witness his influence on the group’s work dealing with the OECD Model Tax Convention, in particular as regards tax avoidance strategies using tax treaties and also the application of tax treaties to partnerships. The former topic is one that led to recent changes to the OECD Model Tax Convention and these changes are the starting point of this article.

The purpose for the changes was to clarify how tax treaties interact with domestic anti-avoidance rules and, more generally, how countries can address tax treaty abuses.

These topics have long been a source of concern for the OECD. The introduction to the 1963 Draft Convention noted that “… the Fiscal Committee has recently brought under study the question of the improper use of double taxation Conventions and of fiscal evasion which can result from the interaction of the Conventions and the domestic laws.” The 1977 Model described the outcome of that study as follows:

“The Committee on Fiscal Affairs has examined the question of the improper use of double taxation conventions but, in view of the complexity of the problem, it has limited itself, for the time being, to discussing the problem briefly in the Commentary on Article 1 and to settling a certain number of special cases […] The Committee intends to make an in-depth study of such problems and of other ways of dealing with them.”

The “in-depth” study to which the 1977 Model referred led to the publication, in 1987, of two reports entitled “Double Taxation Conventions and the Use of Base Companies” and “Double Taxation Conventions and the Use of Conduit Companies“. Based on these two reports, the section on “Improper Use of the Convention” that had been added in 1977 was substantially extended in 1992.S. 454 At the same time, the Introduction to the Model Tax Convention was amended to indicate that “[t]he Committee on Fiscal Affairs continues to examine both the improper use of tax conventions and international tax evasion.”

In 1998, the OECD Committee on Fiscal Affairs released its first report on harmful tax practices. That report included 15 recommendations; recommendation 10 was “that the Commentary on the Model Tax Convention be clarified to remove any uncertainty or ambiguity regarding the compatibility of domestic anti-abuse measures with the Model Tax Convention”. Paragraphs 123 to 125 of the report gave more details as to the type of clarification that was intended:

“123. In various reports, the conclusions of which have been incorporated in different parts of the Commentary on the Model Tax Convention, the Committee has discussed the interaction of domestic anti-avoidance rules (e.g. thin capitalisation, CFC rules, general anti-abuse rules) with tax treaties and has generally concluded that these were compatible with tax treaties. These conclusions, however, are sometimes unclear or expressed in mitigated terms. For example, while paragraphs 22 and 23 of the Commentary on Article 1 indicate that a majority of countries considers that CFC rules do not violate tax treaties and paragraph 37 of the Commentary on Article 10 (Dividends) indicates that CFC rules are not contrary to paragraph 5 of Article 10, the issue of whether such rules are compatible with Article 7 (Business Profits) is not discussed.

124. The Model Tax Convention does not deal with certain domestic anti-abuse provisions and it could be appropriate to provide that tax treaties should generally accommodate the application of such rules. This is an area that has been identified for further study (see section V).

125. The Recommendation is to the effect that the Commentary to the Model Tax Convention be clarified to remove any uncertainty or ambiguity regarding the compatibility of domestic anti-abuse measures with the Model Tax Convention. This Recommendation will help ensure that domestic anti-abuse and judicial doctrines are compatible with tax treaties.”

The changes to the section on “Improper use of the Convention” that were adopted in 2003 were primarily made as a result of the follow-up work on that recommendation. These changes to the Commentary on Article 1 deal with a number of different issues:

• S. 455the specific anti-abuse rules found in tax treaties (paragraphs 9.6 to 10.2);

• the provisions that may be included in a tax treaty to deal with treaty shopping and other forms of abuse (paragraphs 11 to 21.5);

• the interaction between tax treaties and domestic anti-abuse rules (paragraphs 7 to 9.5 and 22 to 26);

• the compatibility of controlled foreign companies (CFC) rules with tax treaties (paragraph 23).

This article deals with two of these issues: the inclusion of specific anti-abuse rules in tax treaties and the interaction between tax treaties and domestic anti-abuse rules.

II. The inclusion of specific anti-abuse rules in tax treaties

Some forms of treaty abuses can be addressed through specific treaty provisions. The OECD Model Tax Convention recognizes the usefulness of such specific anti-abuse rules. As noted in paragraph 10 of the Commentary on Article 1, a number of such rules are included in the OECD Model Tax Convention. These include the concept of “beneficial owner” (in Articles 10, 11, and 12), the “special relationship” rule applicable to interest and royalties (paragraph 6 of Article 11 and paragraph 4 of Article 12), the rule on alienation of shares of immovable property companies (paragraph 4 of Article 13) and the rule on “star-companies” (paragraph 2 of Article 17).

A large part of the section on “Improper use of the Convention” deals with provisions that may be included in a tax treaty to deal with treaty shopping strategies. Most of these provisions were included through the 1992 updateS. 456 as a consequence of the 1987 report on “Double Taxation Conventions and the Use of Conduit Companies”. The 2003 update added a comprehensive limitation-of-benefits provision to the list cautioning, however, that “adaptations may be necessary and that many States prefer other approaches to deal with treaty shopping”.

New paragraphs 21 to 21.5 of the section similarly include alternative provisions that may be included to deal with other forms of treaty abuses; these include:

• provisions which are aimed at entities benefiting from preferential tax regimes;

• provisions which are aimed at particular types of income that is subject to low or no tax under a preferential tax regime;

• anti-abuse rules dealing with source taxation of specific types of income;

• provisions which are aimed at preferential regimes introduced after the signature of the convention.

The OECD Model’s arsenal of specific treaty anti-abuse rules is completed by references, in different parts of the Commentaries, to provisions or modifications that the OECD invites Contracting States to consider including in their bilateral treaties to deal with a number of possible avoidance strategies.

Many of the specific anti-abuse rules put forward in the Commentaries are based on provisions that OECD countries include in their treaties. For instance, all recent United States treaties include a comprehensive limitation-of-benefits provision and a recent example of that provision was the basis for the alternativeS. 457 provision in paragraph 20 of the Commentary on Article 1. Similarly, the articles dealing with dividends, interest and royalties found in recent United Kingdom treaties include a provision according to which the relief provided by the relevant article shall not be available if it was the main purpose or one of the main purposes of any person concerned with the creation or assignment of the property in respect of which the relevant income is paid to take advantage of the article by means of that creation or assignment; that provision was the basis for the alternative provision now found in paragraph 21.4 of the Commentary on Article 1.

Clearly, such specific treaty anti-abuse rules provide more certainty to taxpayers. This is acknowledged in paragraph 9.6 of the Commentary, which explains that such rules can usefully supplement general anti-avoidance rules or judicial approaches. One should not, however, underestimate the risks of relying extensively on specific treaty anti-abuse rules to deal with tax treaty avoidance strategies.

First, specific tax avoidance rules can only be drafted once a particular avoidance strategy has been identified. It would be foolhardy to believe that all potential avoidance strategies can be identified prospectively. Since a specific anti-avoidance rule will often be drafted only after a particular strategy has become a significant problem, taxpayers that first use that strategy will be advantaged. This particular form of reward for innovation has no place in an equitable tax system: there is no reason why taxpayers who have access to the most imaginative, or aggressive, tax advisers should be advantaged over other taxpayers. The ability to frequently amend domestic tax laws may partly address the problem in the case of abuses of domestic laws but since tax treaties take so long to amend or replace, this is a very serious deficiency as regards the inclusion of specific anti-abuse rules in tax treaties.

Second, the inclusion of a specific anti-abuse provision in a treaty can seriously weaken the case as regards the application of general anti-abuse rulesS. 458 or doctrines to other forms of treaty abuses. Adding specific anti-abuse rules to a tax treaty may well create an expectation that all unacceptable avoidance strategies that rely on treaty provisions will be similarly dealt with and cannot, therefore, be challenged under general anti-abuse rules.

That particular risk was identified by the negotiators of the Third Protocol to the Canada-United States tax treaty. That protocol added new Article XXIXA, a comprehensive limitation-of-benefits article, to the treaty. Rather unusually, the article applies unilaterally so as to allow the United States to restrict the benefits of the treaty (it seems that Canada did not want to deal with treaty shopping through such a rule, which had clearly been included as the request of the United States). Paragraph 7, however, expressly clarifies that the inclusion of the article should not be interpreted to restrict in any manner the right of either State to deal with treaty abuses:

“7. It is understood that the fact that the preceding provisions of this Article apply only for the purposes of the application of the Convention by the United States shall not be construed as restricting in any manner the right of a Contracting State to deny benefits under the Convention where it can reasonably be concluded that to do otherwise would result in an abuse of the provisions of the Convention.”

Third, in order to specifically address complex avoidance strategies, complex rules may be required. This is especially the case where these rules seek to address the issue through the application of criteria that leave little room for interpretation rather than through more uncertain criteria such as the purposes of a transaction or arrangement. The comprehensive limitation-of-benefits provision put forward in new paragraph 20 of the Commentary on Article 1 provides a good example: that provision attempts to deal with the issue of treaty shopping through precise criteria but is also the longest put forward in the OECD Model Convention. Complex treaty rules are often difficult to negotiate, are more likely to be literally interpreted and are more arbitrary than short rules that focus on principles.

For these reasons, the inclusion of specific anti-abuses rules in tax treaties cannot provide a satisfactory comprehensive solution to treaty abuses.

S. 459III. Abuse of the treaty, the domestic law or both?

Where no specific treaty anti-abuse rule apply to a particular avoidance strategy involving the provisions of a tax treaty, the OECD Commentary recognizes two possible approaches to dealing with a potential abuse.

One approach is to consider that there is an abuse of the treaty itself and to disregard abusive transactions under a proper interpretation of the relevant treaty provisions that takes account of their context, the treaty’s object and purpose as well as the obligation to interpret these provisions in good faith. There are good international law arguments to support that approach. Also, a number of countries, such as the United States and the United Kingdom, have long used a process of legal interpretation to counteract abuses of their domestic tax laws and it seems entirely appropriate to use a similar approach in the case of tax treaty abuses.

Paragraph 8 of the Commentary on Article 15 may be seen as an example of that approach. That paragraph refers to the situation where a local employer wishing to hire a foreign worker for less then 183 days recruits him through a non-resident intermediary so as to obtain the benefits of the exception from source taxation provided by paragraph 2 of Article 15. According to the paragraph

“To prevent such abuse, in situations of this type, the term “employer” should be interpreted in the context of paragraph 2.[…] In this context, substance should prevail over form, i.e. each case should be examined to see whether the functions of employer were exercised mainly by the intermediary or by the user.”

The second approach is to rely on the anti-abuse rules of domestic law. As explained in new paragraph 9.3 of the Commentary on Article 1, that approach relies on the fact that tax is levied under the provisions of domestic law, not of treaties and, therefore, an abuse involving tax treaty provisions can also be characterised as an abuse of the provisions of domestic law under which tax must be paid.

A reference to that approach may be found in paragraph 18 of the Commentary on Article 5, which deals with abuses of the 12-month exception of paragraph 3 of Article 5 applicable to construction sites. According to the Commentary “[…]such abuses may, depending on the circumstances, fall under the application of legislative or judicial anti-avoidance rules.”

S. 460A possible difficulty with that second approach, however, is that in case of conflict between the provisions of tax treaties and those of domestic law, the provisions of tax treaties must prevail. This is a logical consequence of the principle of “pacta sunt servanda” which is incorporated in Article 26 of the Vienna Convention on the Law of Treaties. Thus, if the application of domestic legislative or judicial anti-avoidance rules had the effect of increasing the tax liability of a taxpayer beyond what is allowed by a tax treaty, this would conflict with the provisions of the treaty and these provisions should prevail under public international law.

In the case of domestic legislative or judicial anti-avoidance rules that clearly focus on abuses, however, such conflicts should not arise. This is the general conclusion of the OECD, which is reflected in new paragraphs 22 and 22.1 of the Commentary on Article 1:

‘22. Other forms of abuse of tax treaties (e.g. the use of a base company) and possible ways to deal with them, including „substance-over-form“, „economic substance“ and general anti-abuse rules have also been analysed, particularly as concerns the question of whether these rules conflict with tax treaties […]

22.1 Such rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability; these rules are not addressed in tax treaties and are therefore not affected by them. Thus, as a general rule and having regard to paragraph 9.5, there will be no conflict. […]”

That view generally corresponds to what was previously presented in the Commentary as the view of the “vast majority of OECD countries”.

S. 461Having concluded that the approach of relying on the anti-abuse rules and judicial doctrines of domestic law does not, as a general rule, conflict with tax treaties, the OECD was therefore able to conclude that “[u]nder both approaches […] States do not have to grant the benefits of a double taxation convention where arrangements that constitute an abuse of the provisions of the convention have been entered into.”

That conclusion leads logically to the question of what is an abuse of a tax treaty. The OECD did not attempt to provide a comprehensive reply to that question, which would have been difficult given the different approaches of its Member countries. Nevertheless, the OECD presented the following general guidance, which was referred to as a “guiding principle”:

“A guiding principle is that the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions.”

This paragraph serves an important purpose as it attempts to balance the need to prevent treaty abuses with the need to ensure that countries respect their treaty obligations. As Arnold puts it “[a] country should not be able to avoid its treaty obligations taking the position that virtually all transactions are abusive and all of its domestic tax rules are anti-avoidance rules.”

Under the guiding principle presented in paragraph 9.5, two elements must be present for certain transactions or arrangements to be found to constitute an abuse of the provisions of a tax treaty:

• a main purpose for entering into these transactions or arrangements was to secure a more favourable tax position, and

• obtaining that more favourable treatment would be contrary to the object and purpose of the relevant provisions.

These two elements are not a creation of the OECD. They underlie a more general concept of abuse of law. As noted by Ward et al.:

“The abuse of rights doctrine, where that has been applied, generally involves a recognition that although a taxpayer has a right to enter into any contract or undertake any transaction which is legal, he abuses that right if he exercises it solely to avoid or reduce taxes. In addition, abuseS. 462 will only be present where the purpose of the applicable tax law has been defeated.” [emphasis added]

While a study of the various general anti-avoidance rules and doctrines developed in OECD countries is beyond the scope of this article, these two elements will also often be found, explicitly or implicitly, in such domestic rules and doctrines. Based on an analysis of international law and of the domestic anti-abuse rules and doctrines of a number of countries, Stef van Weeghel has recommended that these elements be used to identify improper use of tax treaties:

“A number of criteria have been developed in this study to determine whether a particular use of a tax treaty can be labeled ‘improper’. The definition arrived at in chapter 7 contains two main elements used for the determination whether there is improper use of a tax treaty: Such use must have the sole intention to avoid the tax of either or both of the contracting states and must defeat fundamental and enduring expectations and policy objectives shared by both states and therewith the purpose of the treaty in a broad sense.”

S. 463One can also recognize these two elements in the emerging jurisprudence of the European Court of Justice dealing with the conditions under which a measure that hinders the basic freedoms of the Treaty Establishing the European Community could be justified on the basis of the prevention of tax avoidance. In Hughes de Lasteyrie du Saillant and Ministère de l’Économie, des Finances et de l’Industrie, the Court rejected the claim that Article 167a of the CGI might be so justified by saying that this article “is not specifically designed to exclude from a tax advantage purely artificial arrangements aimed at circumventing French tax law”. These two concepts (“artificial arrangements” and “aimed at circumventing French tax law”) can be viewed as roughly similar to the two elements underlying the guiding principle of paragraph 9.5.

It is important to note that paragraphs 9.4 and 9.5 focus on the abusive arrangements to which anti-abuse rules could apply rather than on the rules as such. This is clear from the wording of paragraph 9.4, which provides that “States do not have to grant the benefits of a double taxation convention where arrangements that constitute an abuse of the provisions of the convention have been entered into”; similarly, the principle of paragraph 9.5 refers to the transactions or arrangements that should not be entitled to treaty benefits. The principles of these paragraphs do not, therefore, apply as a test to decide whether or not a particular domestic rule or doctrine conforms to the provisions of a tax treaty. A particular anti-abuse rule may well conform with treaty obligations even when it applies to non-abusive transactions (this would be the case, for example, of a thin capitalisation rule that meets the conditionsS. 464 described in subparagraph 3a) of the Commentary on Article 9 or of controlled foreign companies legislation, as explained in paragraph 23 of the Commentary on Article 1). The conclusions of paragraphs 9.4. and 9.5 would primarily be relevant to justify the application of an anti-abuse rule or approach to a specific abusive case (as described in these two paragraphs) if the application of that rule or approach would prima facie appear to violate specific treaty provisions. Thus, as suggested by the first sentence of paragraph 9.6 and by the wording of paragraph 22, these paragraphs will primarily be relevant as regards the application of general anti-abuse rules or doctrines, which address transactions or arrangements that seem to comply with the specific provisions of the domestic law and of a treaty.

IV. Conclusion

It is trite to say that tax avoidance violates the principles of neutrality and of horizontal and vertical equity. A clearer way of saying essentially the same thing is that the vast majority of taxpayers do not have access to tax havens or to sophisticated tax planning and that they are the ones who bear the costs of tax avoidance through reduced public services or transfer payments, increased tax burden or a combination thereof. It is therefore legitimate for governments to counteract tax avoidance strategies.

While tax treaties are clearly not intended to facilitate tax avoidance, their provisions, like those of domestic laws, are vulnerable to abuses. In the case of abuses of domestic law provisions, however, governments can adopt specifically-targeted anti-avoidance rules as soon as they become aware of these abuses. This may explain why courts are sometimes reluctant to intervene when an avoidance strategy is not specifically caught by such rules. A quick amendment is not, however, a practical option for tax treaties, which can only be amended if and when both Contracting States agree. It is therefore crucial that tax avoidance strategies that make use of tax treaty provisions be prevented through domestic law anti-abuse provisions and, where those are not applicable, through a proper interpretation of tax treaties. This is fully consistent with the good faith requirement embodied in Articles 26 and 31 of the Vienna Convention on the Law of Treaties.