MLI SERIES- ARTICLE 6 – PURPOSE OF A COVERED TAX AGREEMENT AND ARTICLE 7 – PREVENTION OF TREATY ABUSE

The bilateral tax treaties signed by the countries also could not prevent improper use of treaties by companies to pay no or minimum taxes leading to treaty shopping or tax treaty abuse. The Organisation for Economic Co-operation and Development (‘OECD’) has been trying to address such issues through its model tax convention or commentary by introducing concepts such as ‘beneficial owner’, ‘conduit companies’, ‘object and main purpose of arrangement or transaction’ etc. over the years. However, multi-nat`ional companies continued treaty shopping and evaded billions in taxes.

Considering the above, a need was felt for international cooperation to tackle the BEPS risks by arriving at a consensus-based solution. The OECD developed a strategy to address BEPS issues in a harmonized and comprehensive manner to counter weaknesses in the taxation system and confront gaps and mismatches in tax treaties. Hence, the concept of Multilateral Instrument (‘MLI’) was introduced whereby existing tax treaties stood modified to incorporate treaty-related BEPS measures via a single instrument called MLI. Multiple action plans were devised as a part of the BEPS project, and one such plan was Action Plan 6 – Prevention of tax treaty abuse.

2. OVERVIEW OF ACTION PLAN 6

The MLI contains multiple articles, which are divided into 7 parts. Part III, containing Articles 6 to 11, deals with the prevention of treaty abuse. Article 6 covering ‘Purpose of Covered Tax Agreement’ and Article 7 on ‘Prevention of Treaty Abuse’ has been discussed in this article.

Primarily, BEPS Action Plan 6 includes, inter-alia, introduction of title and preamble to every treaty as a minimum requirement along with the insertion of the clause on principal purpose test as well as limitation on benefits.

3. ARTICLE 6 OF MLI – PREAMBLE AS MINIMUM STANDARD

‘Intending to eliminate double taxation with respect to the taxes covered by this agreement 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 agreement for the indirect benefit of residents of third jurisdictions)’.

The main crux of the preamble as the minimum standard is to indicate the intention of the treaty countries to:

a) Eliminate double taxation;

b) Restrict opportunities for non-taxation or reduced taxation through tax evasion/avoidance strategies; and

c) Discourage treaty shopping or treaty abuse.

There is a possibility that the existing treaties may already have a preamble on similar lines. However, considering that multiple nations have commonly agreed upon the comprehensive text, it is desired that the countries adopt modified language of preamble as a substitute or in absence of the current text. However, if two countries believe that the language of preamble in the tax treaty is sufficient, they may continue with the text of preamble in the tax treaty by making a reservation without adopting change as suggested above.

The preamble forms part of the tax treaty and sets the tone and context in the right manner. It constitutes a statement of the object and purpose of the tax treaty.

With regards to the methodology of incorporating new preamble into existing treaties, it being a minimum standard, the countries who subscribe to MLI are presumed to have agreed to the change unless otherwise notified. If a country remains silent on its position without expressing any explicit reservation, it will be presumed that the country has agreed to the adoption of the minimum standard.

4. OPTIONAL ADDITION TO PREAMBLE
MLI provides an option to add following text in the preamble discussed above:

?Desiring to further develop their economic relationship and to enhance their cooperation in tax matters’

The additional text is offered as an option to the signatories of MLI with respect to the treaties that do not already have such a language as a part of its preamble. Only when both the countries expressly agree to adopt additional language will their tax treaty stand modified to include said text as part of the preamble. For example, the UK and Australia have opted for the inclusion of additional language as a part of the preamble. Hence, the UK-Australia tax treaty will have this additional language in addition to the language required as a minimum standard.

5. INDIA’S POSITION TO PREAMBLE AND OPTIONAL ADDITION
India is silent on the adoption of Article 6. Therefore, preamble text as stated above, being a minimum standard shall be deemed to have been adopted by India for its tax treaties. However, India has not opted for optional addition, and hence the same will not be included in the tax treaties.

6. IMPACT OF PREAMBLE ON INDIA’S EXISTING TREATIES

7. INTENT OF PREAMBLE
The main intention behind binding countries which are signatory to the MLI to include new preamble as a minimum requirement is to ensure prevention of inappropriate use of tax treaties leading to double non-taxation or reduced taxation. However, recognizing what is ‘appropriate’ vis-à-vis ‘inappropriate’ use of tax treaty is often complex and strenuous.

In a situation where a company is set up with no / minimum business activity in a particular jurisdiction it may be viewed to be a typical case of inappropriate use of tax treaty. Further, in case of a company being engaged in genuine commercial activities which incidentally leads to double non-taxation may not viewed to be a case of inappropriate use of tax treaty. In such cases, the effect of double non-taxation is not on account of any tax evasion arrangement but in line with the overall object and intent of the tax treaty.

The tax treaty also intends to encourage economic development and co-operation amongst countries. One such case is of India-Mauritius tax treaty wherein the preamble manifests the philosophy of encouraging mutual trade and investment as object of the treaty. In the landmark judgment of Union of India vs. Azadi Bachao Andolan ([2003] 263 ITR 706), the Supreme Court referred to the text of the preamble of the Mauritius Treaty and legitimized treaty shopping as being consistent with India’s intention at the time when the Mauritius treaty was entered. It is pertinent to evaluate whether Supreme Court would have rendered the decision on similar lines if preamble would not bear reference to the text relating to economic development. Further, it would be interesting to see how Courts interpret tax treaties considering the text of new preamble in the tax  treaties.

Mandatory adoption of new preamble is a step in right direction as an anti-abuse measure which keeps a check on treaty shopping and would help countries in collecting taxes in a fair and equitable manner.

8. ARTICLE 7 OF MLI – PREVENTION OF TREATY ABUSE
The BEPS Action Plan 6 Report provides for three alternatives to mitigate treaty abuse viz. the principal purpose test (‘PPT’), simplified limitation of benefit (‘SLOB’) provision and detailed limitation of benefit (‘DLOB’) provision. Under Action Plan 6, as a minimum standard, countries are provided with a choice between adopting the following options for prevention of Treaty Abuse:

(i) Only PPT.

(ii) PPT along with SLOB.

(iii) PPT along with DLOB.

(iv) DLOB supplemented by a mechanism that would deal with conduit arrangements not already dealt with in tax treaties.

The MLI provides for the PPT and SLOB provisions. However, it does not include a draft of the DLOB provision since it may require substantial bilateral customization and may be difficult to incorporate in a multilateral instrument. Further, since the PPT, by itself, can constitute compliance with the minimum standard, the same has been provided for as the default option for prevention of treaty abuse under Article 7 of MLI. However, countries are free to adopt either of the other three approaches as provided above.

9. CONCEPT OF PPT
The concept of PPT provides that where having regard to all relevant facts and circumstances, it is reasonable to conclude that one of the principal purposes of any transaction or arrangement was to obtain treaty benefit, such benefit would be denied unless it is established that the granting of such benefit would be in accordance with the object and purpose of the provisions of the treaty.

The concept of PPT may be dissected as under:

(i) Overriding Provision – The provisions of the PPT are notwithstanding other provisions of the treaty, namely they override the other provisions of the treaty.

(ii) Subjective Test – The test of PPT is subjective. While all relevant facts and circumstances needs to be considered in determining fulfilment of PPT, what constitutes the principal purpose of an arrangement and whether the principal purpose was to obtain a treaty benefit may be subject to varying interpretations.

(iii) Onus of Proof – The onus of proof (namely reasonable basis) required for the tax department to contest non-compliance of PPT is lower than the onus of proof (namely establish with certainty) required for the taxpayer to contend that granting of benefit is in accordance with the object and purpose of the treaty.

(iv) Application of PPT – PPT may fail even if one of the principal purposes of the transaction or arrangement was to obtain treaty benefit. One way to interpret this could be that where the transaction or arrangement would not have taken place or would have taken place in a different manner in the absence of the treaty benefit, then in such cases principal purpose may be said to have been to obtain treaty benefit.

(v) Transaction or Arrangement – The MLI does not define the terms ‘transaction’ or ‘arrangement’. However, the term ‘arrangement’ is defined in section 102(1) of the Income-tax Act, 1961 (‘IT Act’), although for the limited purpose of Chapter XA relating to the General Anti-Avoidance Rule. However, these terms could be interpreted widely and may also include setting up an entity in a particular jurisdiction.

(vi) Benefit – The term ‘benefit’ has also not been defined in the MLI. However, the same has been defined in section 102(3) to include a payment of any kind, whether intangible or intangible form. Further, section 102(10) defines ‘tax benefit’ to include reduction, avoidance or deferral of tax, increase in refund, reduction in incomeor increase in loss. The term ‘benefit’ in the context ofMLI is also intended to be wide in nature to cover the above.

(vii) Taxability in case PPT is not satisfied – Where PPT is not satisfied, the benefit under the treaty may be denied. However, the taxability may not be altered under the treaty by recharacterizing the transaction, disregarding an arrangement, looking through the transaction etc.

(viii) Object and purpose of tax treaty – Even where the PPT is not satisfied, treaty benefit may still be granted where it is proved that the granting of such benefit is in accordance with the objects and purpose of the treaty. The object and purpose of treaty may be gauged from the treaty’s preamble, text of the relevant provision etc. Typically, treaties/treaty provisions include elimination of double taxation, promotion of exchange of goods and services, movement of capital and persons, fostering economic relations, trade and investment, provision of certainty to taxpayers, elimination of discrimination etc. as their objects.

Some of the situations where PPT may be applied to deny treaty benefits are setting up of an intermediate holding company for treaty shopping, assignment of the right to receive a dividend to a beneficial treaty country, holding of board meetings in a particular country to demonstrate residence of the entity in such country etc. Further, some of the situations where the treaty benefit may be provided under the exception to the PPT Rule (i.e. treaty benefit in accordance with object and purpose of tax treaty) include choice of a treaty country for setting up a new manufacturing plant as compared to setting up in a country with no treaty, allowing benefit to an investment fund or a collective investment vehicle set up in a country where majority investors are of that country while some minority investors may be of a different country etc.

In addition to the PPT, the MLI also provides an option to include an additional para empowering the competent authority of a contracting state to grant the treaty benefit upon request from the person even where the same has been denied as a result of the operation of PPT. This shall be the case where the competent authority determines that such benefits would have been granted even in the absence of the transaction or arrangement.

10. APPLICATION OF PPT TO COVERED TAX AGREEMENTS
The PPT applies ‘in place of’ or ‘in absence of’ any existing similar provisions in the treaty. Where a similar PPT provision (which either covers all benefits or is applicable to specific benefits under treaty) is already present in the treaty and the same is notified by both the parties to the CTA, the said provision would be replaced by the PPT under the MLI. Thus, the scope of existing PPT provisions under a CTA would get expanded by the operation of the MLI. Where no such provision is present, the PPT under MLI would be added to the treaty. Further, where only one of the parties to the CTA notifies a similar existing provision in the treaty or where none of the parties to the CTA notify a similar existing provision, the PPT under MLI would apply and prevail over the existing provision and the MLI PPT would supersede the existing provision to the extent that such existing provision is incompatible with the MLI PPT.

However, the optional para empowering the competent authority to grant treaty benefit would only apply where both the parties to CTA have chosen to adopt the same.

11. CONCEPT OF SLOB
As discussed earlier, the SLOB provision is an optional provision which may be adopted as a supplement to the PPT. It provides for objective conditions for entitlement to benefits under a CTA. Basically, the SLOB test provides that a resident of a contracting state would be entitled to treaty benefits which are otherwise available under the CTA only where such resident:

(i) Is a ‘qualified person’; or

(ii) Is engaged in active conduct of business; or
(iii) At least 75% beneficial interest in such person is directly or indirectly owned by equivalent beneficiaries; or

(iv) Is granted benefit by the competent authority irrespective subject to fulfilment of PPT.

However, the following benefits under the treaty are not subject to the SLOB test:

(i) Determination of residence of dual resident entities (Para 3 of Article 4).

(ii) Corresponding adjustment (Para 2 of Article 9).

(iii) Mutual agreement procedure (Article 25).

Some of the important concepts for test of SLOB are outlined below:

12. APPLICATION OF SLOB TO CTAs
The SLOB applies to a CTA only where both the parties to CTA have chosen to apply it. Where only one of the parties or none of the parties have adopted the SLOB, the PPT would apply.

Further, where one of the parties to a CTA has chosen to apply the SLOB while the other party has not, the first party has an option to opt-out of Article 7 in its entirety namely Article 7 (including PPT) would not apply in such a case. In order to discourage such a situation, MLI provides the party not applying the SLOB to opt for either of the following:

(i) Symmetrical application of SLOB: SLOB would apply symmetrically under CTAs with parties that have originally chosen to apply SLOB. For example, where State X has opted for SLOB while State Y has opted only for PPT, State Y may opt for application of SLOB symmetrically to X-Y treaty. In such a case from the perspective of State Y, SLOB clause would apply only for the limited purpose of X-Y treaty. SLOB would not be applicable to any of the Y’s treaties with other States where such other States have not chosen to apply SLOB.

(ii) Asymmetrical application of SLOB: In the earlier example, where State Y opts for asymmetrical application, State X would test both PPT and SLOB while granting treaty benefits while State Y would only test for PPT.

It may be noted that opting for either of symmetrical or asymmetrical option is not mandatory for State Y. If none of the options is opted, the SLOB shall not apply, and only PPT shall apply. However, State X would then have an option of opting out of the entire Article 7, and if such option is exercised, neither PPT nor SLOB shall apply. However, in such a scenario it is expected that countries should endeavour to each a mutually satisfactory solution that meets minimum standard for preventing treaty abuse. In the context of Indian treaties, considering that India has opted for Article 7, the application of PPT or PPT and SLOB would depend upon how the other country chooses to apply Article 7. The impact of Article 7 on select Indian tax treaties is discussed in the subsequent paragraphs.

SLOB also applies ‘in place of’ or ‘in absence of’ similar provisions in the CTA. Where a treaty already has existing similar SLOB provisions, the states may notify the same and the MLI SLOB shall apply in place of the existing SLOB provision upon notification by both the states. The application of SLOB would be similar to that or PPT as discussed in
para 10.1.

13. INDIA’S POSITIONS ON ARTICLE 7
India has chosen to apply PPT as an interim measure in its final notification. However, where possible, it intends to adopt a LOB provision, in addition to or in replacement of PPT, through bilateral negotiation. India has not opted to apply the optional provision empowering the competent authority to grant treaty benefit even where PPT is not met. Further, India has also opted to apply the SLOB to all  its treaties.

14. IMPACT OF ARTICLE 7 ON INDIA’S TREATIES
The impact of MLI on some of India’s prominent tax treaties is outlined in the Table below. The analysis in the below Table is considering that India has opted for PPT and SLOB provisions.

15. INTERPLAY OF PPT, SLOB AND GAAR

It is also pertinent to consider the interplay of PPT and General Anti-Avoidance Rules (‘GAAR’) under the IT Act. The table below provides a comparative analysis of these provisions.

It may be noted from the above that the test under PPT is more stringent than under GAAR. Accordingly, it is less likely that GAAR would apply where the PPT is satisfied. However, it would be interesting to see the manner in which GAAR provisions may apply where treaty benefit is provided under the exception to the PPT rule taking into account the object or purpose of the treaty.

16. CONCLUSION
With the introduction of the preamble in all CTAs, the same is likely to assume increasing significance in the interpretation of tax treaties and the provision of benefits thereunder, including by judicial forums. Any double non-taxation or treaty shopping case is likely to be subject to extensive scrutiny. Further, group holding structures, cross border transactions and arrangements planned by multinational corporations would need extensive examination with respect to the fulfilment of PPT in addition to already existing anti-avoidance measures. Further, since many countries have not opted for SLOB, the impact of SLOB provisions would be limited to select treaties entered into by India.

The importance of commercial substance and rationale is likely to assume prime significance and it is imperative that business decisions be driven by commercial factors rather than primarily by tax reasons. Going forward, the significance of adequate documentation for demonstrating the commercial rationale of entering into any transaction / arrangement cannot be undermined.