Addressing tax treaty abuse

The journey so far and the road ahead

Governments worldwide have been up in arms against the egregious tax planning undertaken by multinational corporations. Taxpayers take advantage of the vast tax treaty network that countries have in place and can inappropriately reduce their tax liability to an extent where application of tax treaties results in double non-taxation.

Since tax treaties are entered into with the objective of eliminating double taxation, such egregious tax planning defeats the very purpose of tax treaties and also results in the erosion of the tax base.

A number of steps have been taken by governments to address treaty abuse. On its part, India has adopted multiple approaches that include (a) a unilateral approach of bringing into force GAAR (General Anti-Avoidance Rule); (b) a bilateral approach in terms of which existing tax treaties have been amended to incorporate anti-abuse provisions by way of a LOB (Limitation of Benefits) clause; and (c) a multilateral approach in terms of which India will enter into an MLC (Multilateral Convention) under the BEPS (Base Erosion and Profit Shifting) project, which will introduce anti-abuse rules in treaties with countries which are notified by India.

Let us take a look at the impact of these approaches.

GAAR implications

Under GAAR, Indian tax authorities have been given powers to deny tax benefits in the cases of “impermissible avoidance arrangements” (IAA). An IAA is an arrangement entered into between parties where the main purpose is to obtain a tax benefit and satisfies one or more of the following: (a) non-arm’s length dealings; (b) misuse or abuse of the provisions of the tax provisions; (c) lack of commercial substance; and (d) arrangement similar to that employed for non-bona fide purposes.

Given that GAAR gives plenary powers to the tax authorities to restructure the entire business structure of a taxpayer and it is unilateral in nature, taxpayers are liable for a severe hit if it is invoked.

Under the bilateral approach, India has amended various treaties, most notably Mauritius, Singapore, and Cyprus wherein the taxpayer needs to satisfy minimum criteria failing which the tax benefits under the treaty shall be denied. For instance, the India-Singapore tax treaty provides for a financial threshold of expenditure that needs to be met for claiming treaty benefits.

Under the multilateral approach, India will be signing the MLC under the BEPS Project. The BEPS is an inclusive framework that has brought together more than 100 countries to collaborate on the OECD/G20 BEPS package. The package consists of 15 actions that equip governments with domestic and international instruments needed to address BEPS.

The MLC will be signed on June 7, 2017 by over 100 countries wherein the countries will notify the tax treaties that they intend to be covered by the MLC. The MLC will be applicable on reciprocity basis, meaning that two countries need to notify each other for the MLC to be applicable.

Once a tax treaty is covered by the MLC, the treaty will stand automatically amended in line with the relevant provisions of the MLC.

The MLC provides for a minimum standard towards addressing BEPS Action 6 which deals with the prevention of treaty abuse. This minimum standard requires for the countries to agree to (a) a Principal Purpose Test (PPT) which is in the nature of a general anti-abuse rule based on the intent of the arrangement; or (b) a PPT supplemented with a simplified or a detailed LOB clause; or (c) a detailed LOB clause.

Clarification needed

As is apparent from the discussion above, India has adopted a multi-pronged strategy to address treaty abuse. The question arises whether GAAR still remains the proverbial nuclear option. In other words, once a taxpayer overcomes the hurdles of satisfying the LOB clause in a bilateral treaty or the anti-abuse provisions of the MLC under a covered tax agreement, can GAAR still be invoked?

The Central Board of Direct Taxes (CBDT) came out with a circular earlier this year in January where it has “clarified” that GAAR may apply even where there are Specific Anti Avoidance Rules in place because such rules may not address all situations of abuse; and the tax treaty incorporates a LOB clause unless the case of avoidance is “sufficiently addressed” by the LOB clause in the treaty.

Taxpayers were initially under the impression that where treaties have been recently amended and/or which will be subject to the MLC, will be left outside the ambit of GAAR.

However, the CBDT circular has muddied the waters considerably. It has been settled law that where a specific law applies, the general law must stand aside. However, insofar as GAAR is considered, the government has adopted a diametrically opposite approach.

On the other hand, for treaties where an LOB clause is in place (with or without the anti-abuse provisions of the MLC), the circular mandates that GAAR will not be invoked if the LOB clause has “sufficiently addressed” the avoidance. The words “sufficiently addressed” are neither defined nor clarified in the Circular and add subjectivity to the implementation of GAAR.

One would hope that once the MLC is signed, the government will come out with a clarification specifically excluding from the ambit of GAAR, the tax benefits claimed under any treaty that is covered by the MLC.

The writer is Managing Partner, Nangia & Co LLP

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