BACKGROUND
On 7th June 2017, representatives
of 68 jurisdictions met at the OECD headquarters in Paris to sign the
multilateral instrument
(MLI). The MLI is an outcome of the Base Erosion and Profit Sharing (BEPS)
Action 15, which specifically addresses the issue of how to modify existing
bilateral tax treaties in order to implement BEPS tax treaty measures. The
MLI is an innovative and swift way of modifying bilateral tax treaties without
getting caught in the time-consuming process of re-negotiating each tax treaty.
The implementation of the MLI is expected to have a far-reaching impact on the
existing bilateral tax treaties. The OECD estimates that potentially 1,100
existing bilateral tax treaties are set to be modified. This is a turning
point in the history of international taxation.
SCOPE OF MLI FROM INDIA’S PERSPECTIVE
As of now, the MLI is signed but not yet
effective. The MLI will enter into force on the first date of the month after
three calendar months from the date when at least five countries deposit the
instrument of ratification, acceptance or approval; detailed provisions are
also there for entry into effect of the MLI.
Once the MLI is effective, it will modify an
existing bilateral tax treaty only if both the countries have notified the tax
treaty for the purposes of MLI. Under the MLI framework, such a tax treaty is
referred to as the covered tax agreement (CTA). India has notified all its tax
treaties (such as tax treaties with USA, UK, Singapore, Netherlands, Japan,
Luxembourg, etc.) as CTAs for the purposes of MLI. However, there are
some countries such as Mauritius, Germany and China who have chosen not to
notify their tax treaty with India – accordingly, the MLI will not apply to
India’s tax treaties with Mauritius, Germany and China. Further, USA and Brazil
are not signatories to the MLI itself. Accordingly, apart from tax treaties
with a few countries, most of India’s tax treaties will stand modified when the
MLI becomes effective.
It may be noted that all tax treaties will
not stand modified at the same time. The effective date of MLI for each
signatory country will vary depending upon when that country signed the MLI.
The MLI provisions will apply only after the MLI has become effective for both
countries.
MINIMUM STANDARDS OF BEPS ACTION 6
IMPLEMENTED THROUGH MLI
The MLI implements two minimum BEPS
standards relating to prevention of tax treaty abuse (BEPS Action 6) and
improvement of dispute resolution (BEPS Action 14). In this article, we are
discussing the impact of MLI on India’s tax treaties with respect to BEPS
Action 6.
The BEPS Action
6 identified treaty abuse, and in particular treaty shopping, as one of the
most important sources of BEPS concerns.Taxpayers engaged in treaty shopping
and other treaty strategies claim treaty benefits in situations where these
benefits are not intended to be granted, thereby depriving countries of tax
revenues. Therefore, countries have come together to include anti-abuse
provisions in their tax treaties, including a minimum standard to counter
treaty shopping. The BEPS Action 6 includes three alternative rules to address
tax treaty abuse:
1. Principal purpose test
(PPT) rule (a general anti-abuse rule based on the principal purpose of
transactions or arrangements)
2. PPT rule, supplemented with
either simplified or detailed limitation of benefits (LOB) rule (a specific
anti-abuse rule which limits the availability of treaty benefits to persons
that meet certain conditions)
3. Detailed LOB rule,
supplemented by a mechanism that would deal with conduit arrangements not
already dealt with in tax treaties.
PPT rule
The MLI presents the PPT rule as the
default option (as the PPT rule meets the minimum standard recommended under
BEPS Action 6 on a standalone basis). Being a
minimum standard, these are mandatory provisions of the MLI and therefore, the
countries who have signed the MLI cannot typically opt out of these provisions.
As an exception, the countries can opt out if a tax treaty already meets the
minimum standards or if it is intended to adopt a combination of a detailed LOB
provision and either rules to address conduit financing structures or a PPT.
Accordingly, generally speaking, PPT rule of the MLI will replace the existing
anti-abuse provision in the tax treaty, or will be inserted in the absence of
anti-abuse provision in the tax treaty. For example, India’s tax treaties with
Canada, Denmark, France, Ireland, Japan, Netherlands, and Sweden do not have an
anti-abuse provision and therefore, the PPT rule of the MLI will be inserted
into those tax treaties.
The PPT rule of the MLI provides that a
benefit under a tax treaty shall not be granted if it is reasonable to
conclude, having regard to all relevant facts and circumstances, that obtaining
the benefit was one of the principal purposes of any arrangement or transaction
that resulted directly or indirectly in that benefit. A classic example is
where the PPT rule addresses treaty shopping by multinational companies who set
up ‘letterbox’ or ‘conduit’ companies which do not have substance in reality
and exist only to take advantage of the tax treaty. With the operation of the
PPT rule, the tax treaty benefits would be denied to such ‘letterbox’ or
‘conduit’ companies which are set up primarily with the intention to take
advantage of a favourable tax treaty. However, such benefit may be granted if
it is established that granting that benefit in these circumstances would be in
accordance with the object and purpose of the relevant provisions of the tax treaty.
The explanatory statement to the MLI
clarifies that the PPT rule of the MLI will not only replace the existing PPT
rules that deny all tax benefits under a particular tax treaty (a general
anti-abuse rule) but also those existing rules that deny tax benefits under
specific articles such as dividends, royalties, interest, income from
employment, other income and elimination of double taxation. This will ensure
that narrower provisions are replaced by the broader PPT rule of the MLI. In
case of a tax treaty that does not already contain a PPT rule, the PPT rule of
the MLI will be added. All these changes to the tax treaty are going to make
treaty shopping difficult. The amendments to the tax treaty arising from
operation of MLI will be prospective. Further, there is no grandfathering
clause available under the MLI provisions for the existing structures. The taxpayers
may have to evaluate how to align their structures with the amended tax
treaties.
The PPT rule of the MLI refers to “one of
the principal purpose” as opposed to “principal purpose” or “main purpose” or
“primary purpose”. Thus, the PPT rule of the MLI is broader than some of the
existing PPT rules contained in tax treaties which only refer to main or
principal or primary purpose. Therefore, the PPT rule of the MLI, once
incorporated into the tax treaties may broaden the scope of anti-abuse provision.
Existing structures which have been put in place simply to take advantage of
the tax treaties and which do not have any substance would be adversely hit by
the amended tax treaties.
Simplified LOB rule
In addition to the PPT rule under the MLI, a
country may also opt to apply a simplified or detailed LOB rule. Under the MLI,
an optional provision will be applicable to a tax treaty only if both the
countries have opted for such provision. If one of the countries has not opted
for it, the optional provision will not be applicable to the CTA. Thus, the
simplified LOB rule (an optional provision) will be applicable to a particular
tax treaty only if both the countries to the tax treaty have exercised the
choice to opt for it. While India has chosen to apply the simplified LOB, very
few other countries
have made a similar choice. Practically, simplified LOB will not get
incorporated into India’s tax treaties, except where the other country has also
opted for such rule (such as, Bulgaria, Colombia, Indonesia, Russia, Slovak
Republic and Uruguay). Though the inclusion of PPT rule and simplified LOB rule
makes the anti-abuse provisions in the tax treaty stronger, from an India tax
treaty perspective, the PPT rule is going to be relevant as very few countries
have opted for simplified LOB rule.
Detailed LOB
The detailed LOB is out of the ambit of the
MLI and does not provide for the text of the detailed LOB as it requires
substantial bilateral customisation. Instead, countries that prefer to address
treaty abuse by adopting a detailed LOB provision are permitted to opt out of
the PPT and agree instead to endeavour to reach a bilateral agreement that
satisfies the minimum standard.
IMPACT ON SELECT INDIA’S TAX TREATIES
India-UK
Article 28C of the India-UK tax treaty,
which is a general anti-abuse provision, will stand replaced by the PPT rule of
the MLI as India and UK both have notified Article 28C for the purposes of MLI.
The PPT rule of the MLI provides for a carve-out in case where the tax benefits
are in accordance with the purpose and object of the tax treaty whereas Article
28C of India-UK tax treaty does not have such a carve-out. Therefore, the
replacement of the PPT rule in place of Article 28C of the India-UK tax treaty
may lead to relaxation of the general anti-abuse provision in the tax treaty.
The UK has also notified anti-abuse
provisions contained in Articles 11(6), 12(11) and 13(9) of the India-UK tax
treaty for the purposes of application of MLI; however, India has not notified
these provisions leading to notification mismatch. Based on the step-by-step
process outlined by the OECD, the PPT rule of the MLI will supersede these
articles to the extent they are incompatible with the PPT rule. India and UK
are not on the same page in case of Articles 11(6), 12(11) and 13(9) of the
India-UK tax treaty.
India-Singapore
The India-Singapore tax treaty contains
specific anti-abuse provisions which deny tax treaty benefits in relation to
capital gains. These provisions are in the nature of a specific anti-avoidance
rule (SAAR) and will not be impacted by the PPT rule. The PPT rule will
accordingly co-exist with the capital gains SAAR. At this stage, it is unclear
as to how this will play out. It will suffice to say that MLI will make this
treaty one of the most complicated.
India-Mauritius
Mauritius has not notified the
India-Mauritius tax treaty as a CTA, and accordingly, the PPT rules will not be
included as part of the tax treaty.
India-Luxembourg
The general anti-abuse provision contained
under Articles 29(2) and (3) of the India-Luxembourg tax treaty can be regarded
as broader in scope than the PPT under the MLI. As India and Luxembourg have
notified the Articles 29(2) and (3), the PPT under the MLI will replace the
aforementioned articles of the India-Luxembourg tax treaty. Thus, there is a
relaxation of the threshold.
India’s tax treaties with Canada, Denmark,
France, Ireland, Japan, Netherlands, Sweden
These tax treaties do not have an anti-abuse
provision and therefore, the PPT rule of the MLI will be inserted into the tax
treaty.
INTERPLAY BETWEEN PPT RULE OF THE MLI AND
GENERAL ANTI-AVOIDANCE RULE (GAAR) UNDER THE INCOME-TAX ACT, 1961
Scope of PPT rule of the MLI and GAAR
The scope of operation of the PPT rule of
the MLI and GAAR are different; whereas the PPT rule applies only to tax treaty
abuse, the GAAR applies to all kinds of abuse of the tax provisions (including
tax treaty abuse). The PPT rule of the MLI is different than GAAR when it comes
to the use of the terms “one of the principal purposes” as opposed to “main
purpose” under the GAAR. An arrangement which has more than one principal/main
purpose (of which obtaining tax benefit is one, but is not the main purpose)
may get covered under the PPT rule of the MLI, but may not attract GAAR.
Moreover, for GAAR to apply, the transaction should also not be at arm’s
length/ result in abuse of provisions of law/lack or deem to lack commercial
substance/is not bona fide. In contrast, the PPT rule of the MLI
provides a carve-out in terms of which the tax benefits will not be adversely
impacted by the PPT rule of the MLI, if such tax benefits are in line with the
purpose and objects of the tax treaty. Therefore, it cannot be generalised
whether PPT rule of the MLI or GAAR is broader in scope.
Interaction between PPT rule and GAAR
Let’s consider a situation where if the PPT
rule were applied, the tax treaty benefits would be denied; however, if the
GAAR were invoked, the tax treaty benefits would not be denied. The Income-tax
Act, 1961 (ITA) broadly provides that a taxpayer can apply the provisions of
the ITA or the tax treaty, whichever is beneficial. Relying on this provision,
can a taxpayer contend that it wants to be governed by the provisions of the
GAAR under the ITA and not the PPT rule under the tax treaty? This seems a
difficult proposition, as once the taxpayer elects to claim the benefits of a
tax treaty (say, reduced withholding tax on technical service fees), the entire
treaty (including the PPT rule) has to be considered, leading to the benefit
not being available.
To summarise, once a taxpayer seeks to claim
a tax treaty benefit, the PPT rule is to be examined to see whether the benefit
is to be granted or not. Thereafter, even if the PPT rule is not triggered, it
may be open to the tax authorities to deny the tax treaty benefit by invoking
the GAAR.
Implementation and administration of GAAR
The Indian tax authorities have the right
to deny tax treaty benefits if the GAAR is invoked in a particular case. It all boils down to how the Indian tax authorities will administer
the GAAR. In the context of the LOB rule, the Indian tax authorities have
clarified that GAAR will be invoked in cases where they believe that anti-abuse
rules under the tax treaty have fallen short of preventing the mischief of tax
treaty abuse. There are checks and balances provided under the GAAR in order to
prevent an overzealous tax officer from involving GAAR in every case. Any
proposal to invoke GAAR will be vetted by senior tax authorities at the first
stage and by another panel at the second stage that will be headed by a High
Court Judge. However, time will be the best judge of how Indian tax authorities
implement and administer the GAAR.
It is pertinent to note that these processes
and safeguards for invoking GAAR are strictly not applicable to the PPT rule. We will need to see whether these processes and safeguards are
extended for applying the PPT rule as well – clarifications on this are awaited
from the Indian tax authorities.
CONCLUSION
India is at the forefront in the fight
against tax avoidance and black money. The BEPS project and its implementation
through the MLI is an important opportunity available to the Indian and foreign
governments to strengthen their tax treaties to tackle the issue of tax treaty
shopping. _
