On 24 November 2016, the Organisation for Economic Cooperation and Development (“OECD”) adopted the multilateral convention composed of the multilateral instrument (“MLI”) and explanatory statements (“ES”).
The MLI has been negotiated by more than 100 jurisdictions and aims at swiftly implementing the tax treaty related measures contained in the OECD/G20 Base Erosion Profit Shifting (“BEPS”) Project. The implementation of these measures on a treaty-by-treaty basis was considered too lengthy and hence Action 15 of BEPS Project recommended the development of the MLI which, once implemented, will transpose these measures into more than 2,000 tax treaties worldwide.
The MLI includes the so-called treaty-related minimum standards which may be implemented in different manners, through certain opt-in or opt-out mechanisms in order to accommodate the positions of the different States, but which nevertheless apply on a mandatory basis (except if the relevant treaty already meets the minimum standard). It also includes provisions that go beyond the minimum standards and which may or may not be implemented at the option of the individual States through appropriate reservations.
The MLI directly amends the bilateral tax treaties that are in force between the signatory States. Each State must however make a notification to the secretary-general of the OECD, who is appointed as Depositary, listing the treaties to be covered by the MLI (the “Covered Treaties”), as well as the options implemented by the relevant State in the Covered Treaties.
The tax treaty related measures of the BEPS Project include Action 2 on hybrid mismatches, Action 6 on treaty abuse, Action 7 on the artificial avoidance of the permanent establishment (“PE”) status and Action 14 on dispute resolution and arbitration. Only Action 6 and the Principal Purpose Test (“PPT”) as well as the dispute resolution mechanism under the mutual agreement procedure will have to be implemented as minimum standards.
1. Hybrid mismatches (Action 2 of the BEPS Project)
Article 3 of the MLI provides for certain rules regarding so-called hybrid mismatches, in particular as regards tax transparent entities, dual residence and elimination of double taxation. These provisions are optional and hence the implementation thereof depends on each Contracting State.
1.1. Transparent entities
Article 3.1 of the MLI introduces a new rule as regards the application of a tax treaty to the income derived from tax transparent entities. Accordingly, income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting State is considered to be income of a resident of a Contracting State but only to the extent that the income is treated, for purposes of taxation by that State, as the income of a resident of that State.
To take an example, it is assumed that State A and State B have implemented Article 3.1 of the MLI. A Borrower resident in State A pays interest to a wholly or partly tax transparent Lender established in State B. State A considers that the Lender established in State B is a company and taxes the Lender on the interest that it receives from the Borrower in State A. State B however treats the Lender as a partnership and the 2 partners who share the partnership’s income equally are each taxed for half the income. One of the partners is resident in State B and the other resident in a State that has not concluded a tax treaty with either State A or B. According to Article 3.1 of the MLI, half of the interest is considered income of a resident of State B.
Article 3.1 of the MLI follows the conclusions of the OECD’s report on the application of the OECD Model Tax Convention to Partnerships and ensures that the benefits of a tax treaty are granted to income derived by a tax transparent entity established in a Contracting State, provided the income is treated for tax purposes by that State as the income of a resident of that State.
1.2. Dual residency
In case a person other than an individual is a resident of both Contracting States, article 4 of the MLI provides that the competent authorities must determine the residence of said person by mutual agreement on the basis of a tie-breaker which takes into account the place of effective management, the place of incorporation or any other relevant factors. In the event no mutual agreement may be reached by the competent tax authorities, said person is not entitled to any tax relief or exemption provided by the tax treaty, except to the extent and in such manner as may be agreed on by the competent authorities.
1.3. Elimination of double taxation
Article 5 of the MLI provides 3 optional alternative methods for the elimination of double taxation:
- under option A, provisions of a Covered Treaty that would otherwise exempt income derived or capital owned by a resident of a Contracting State from tax in the other Contracting State do not apply if the other Contracting State applies the Covered Treaty to exempt such income or capital from tax or to limit the rate of taxation thereof (in the latter case, a tax credit should be granted by the State of residence);
- under option B, provisions of a Covered Treaty that would otherwise exempt income derived from capital owned by a resident of a Contracting State from tax in the other Contracting State given that such income is treated as a dividend do not apply if such income gives rise to a deduction from taxable profits of a resident of the other Contracting State. In such case, a tax credit should be granted for the income tax paid in the source State; and
- under option C, the resident State exclusively uses the credit method in order to eliminate double taxation.
2. Treaty abuse (Action 6 of the BEPS Project)
2.1. Minimum standard
Article 6 of the MLI introduces the minimum standard for protection against tax treaty abuse as an express statement in the preamble of the Covered Treaty as follows: 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)”. It should be noted that such inclusion is a minimum standard and hence mandatory. This provision may further allow a Contracting State to apply its domestic general anti-abuse rules to a given transaction.
2.2. PPT and LOB
Article 7 of the MLI provides for 3 alternative rules to address situations of treaty abuse. As a minimum, one of the following options must be implemented:
- A Principal Purpose Test (“PPT”) only;
- A PPT and a Limitation on Benefits (“LOB”) provision; or
- A detailed LOB provision, supplemented by a mechanism that deals with conduit arrangements (if not yet included in the relevant treaty).
Under the PPT, a benefit of a Covered Treaty is denied if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is in accordance with the object and purpose of the relevant treaty provisions.
The PPT may be supplemented by a LOB clause. The MLI does not provide for a standard detailed LOB, as foreseen in the final report on Action 6, but merely states that a detailed LOB clause may be agreed on bilaterally by the relevant States. As a result, only a simplified LOB clause is included in the MLI which provides that the benefit of a Covered Treaty is only accessible to a so-called “qualified person”, unless the person is engaged in the active conduct of a business. The qualified person must fulfil certain conditions that ensure that such person has indeed a sufficiently strong link with the Residence State in order to benefit from the Covered Treaty.
It is noteworthy to mention that the detailed LOB clause foreseen in the final report of Action 6 also addresses the situation of collective investment funds (“CIV”) but since the relevant provisions have not been introduced into the MLI uncertainty as regards their treatment persists. Similarly, the application of the PPT or the LOB clause in respect of non-CIV funds has not been addressed by the MLI or the ES. A consultation document thereon was released earlier this year by the OECD, which confirmed that it is continuing to examine issues relating to the treaty entitlement of non-CIV funds in order to ensure that the new treaty provisions included in the BEPS Action 6 Report adequately address the treaty entitlement of these funds. Accordingly, a separate report thereon is expected to be released by the OECD.
2.3. Dividend transfer restriction
Article 8 of the MLI gives Contracting States the option of adding a minimum shareholding period of 365 days in the Covered Treaty as a condition for granting a reduced withholding tax rate or exemption on dividends derived from a qualified subsidiary.
2.4. Capital gains derived indirectly from real estate
According to Article 13 (4) of the OECD Model Tax Convention, gains derived by a resident of a Contracting State from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other State. In order to avoid situations where assets are contributed to an entity shortly before the sale of shares or comparable interests in that entity in order to dilute the proportion of the value of the entity that is derived from immovable property, the MLI (i) introduces a testing period for determining whether the condition on the value threshold is met and (ii) expands the scope of interests covered by that paragraph to include interests comparable to shares, such as interests in a partnership or trust. Accordingly, the relevant provisions allowing the source State to tax such capital gains may continue to apply if the relevant value threshold is met at any time during the 365 days preceding the alienation; and may apply not only to shares but also to comparable interests, such as interests in a partnership or trust.
2.5. Anti-abuse rule for exempt or low-taxed PE
Article 10 of the MLI addresses the case where an enterprise of a Contracting State derives income from the other Contracting State and the first-mentioned State treats such income as exempt income attributable to a permanent establishment of the enterprise situated in a third jurisdiction.
In such case, the MLI gives State B the option of denying treaty benefits (e.g. exemption) to income derived from the permanent establishment situated in State A, except if the income is derived from the active conduct of a business carried on through such permanent establishment.
2.6. Saving clause
The MLI also provides for an optional “saving clause” which preserves the right of a Contracting Jurisdiction to tax its own residents. Accordingly, the Covered Treaty should not affect the taxation by a Contracting State of its residents except with respect to the benefits granted by such Covered Treaty.
3. Artificial avoidance of the PE status (Action 7 of the BEPS Project)
Article 12 of the MLI changes the treaty definition of the permanent establishment to prevent the artificial avoidance of permanent establishment status through the use of commissionnaire arrangements, specific activity exemptions and the artificial splitting-up of contracts:
- Commissionnaire arrangements
Under the current PE definition of the OECD Model Tax Convention, an enterprise that uses a commissionnaire arrangement for the sale of assets in another State (i.e. a person that sells products in a State in its own name but on behalf of that foreign enterprise) avoids having a PE in the State where the sale actually occurs while the commissionnaire, not being the owner of the assets, only receives remuneration for his services.
This practice has been considered abusive by the OECD and hence article 13 of the MLI amends the definition of PE to include independent agents if they act for the foreign enterprise and habitually play the principal role leading to the conclusion of contracts that are routinely concluded without any material modification by the enterprise. The amendment remains an option for the Contracting States.
- Specific activity exemptions
The current OECD Model Tax Convention lists a certain number of activities that are not constitutive of a PE (so-called “specific activity exemptions”), e.g. preparatory or auxiliary activities. However, given the changes initiated by the digital economy, the OECD has considered that the list needs to be revisited and introduced optional amendments thereto in article 13 of the MLI.
- Splitting-up contracts
According to the OECD’s final report of Action 7, the segmentation of contracts is another potential strategy for the artificial avoidance of PE. The MLI therefore amends the existing 12-month threshold for determining the existence of PE in order to take into account any activities carried out by a particular enterprise in a jurisdiction during one or more periods of time, which aggregated, exceed 30 days (within the 12-month threshold).
4. Dispute resolution and arbitration (Action 14 of the BEPS Project)
Article 16 of the MLI introduces a mandatory mutual agreement procedure: a person who considers that the actions of one or both of the Contracting States result in taxation which is not in accordance with the provisions of the Covered Treaty may present the case to the competent authority of either Contracting Jurisdiction within three years. The competent authority must then resolve the case, either by itself or by mutual agreement with the competent authority of the other Contracting State.
Article 17 of the MLI further introduces a mandatory corresponding adjustment of tax charged on profits in one Contracting State in case the other Contracting State includes a portion of those taxable profits under applicable transfer pricing rules.
An optional clause for mandatory binding arbitration is contained in the MLI which will allow participating countries to limit the cases eligible for arbitration (based on reciprocal agreements).
Implementation / Timing
- The MLI will be open for signature as of 31 December 2016, although a formal signing ceremony is planned to be held in Paris in June 2017.
- After the signature, Contracting States must complete their domestic procedure to ratify the MLI. Under Luxembourg law, this requires the transposition of the MLI into domestic law through the Parliament.
- After ratification, the Contracting States must notify the Depository and provide a list of Covered Treaties and options.
- The MLI will then enter into force between the Contracting States on the 1st day of the month following the expiration of a period of 3 calendar months (beginning on the date of deposit of the fifth notification).
- The provisions of this MLI will have effect with respect to a Covered Treaty:
-with respect to taxes withheld at source on the first day of the next calendar year that begins on or after the dates on which the MLI enters into force between the Contracting States; and
-with respect to all other taxes, for taxable periods after the expiration of a period of generally 6 calendar months after the dates on which the MLI enters into force between the Contracting States.
The MLI implements a number of tax treaty related measures foreseen by the BEPS project, while other non-treaty related BEPS Actions are addressed in the EU Anti-tax avoidance directive (“ATAD”). The practical impact of the MLI will depend on the implementation of the various options provided by the MLI. Although the Luxembourg government has not yet published its position in this respect, at least the PPT clause and the mutual agreement procedure will need to be implemented. As a result, we recommend that our clients review their current investment structures as regards compliance with the MLI and the ATAD and remind you that our tax team is at your disposal to further guide you towards the appropriate solution.