Base Erosion Profit Shifting
Action 6 Report – Preventing the
Granting of Treaty Benefits in Inappropriate Circumstances
Action 6 of the BEPS Action
plan identified treaty abuse and in particular treaty shopping, as one of the
most important sources of BEPS concerns
Action 6 Report makes
following recommendations with regard to treaty shopping:-
1. Treaties
include in their title and preamble, a clear statement that contracting states
intend to avoid creating opportunities for non-taxation or reduced taxation
through tax evasion or avoidance including treaty shopping arrangement.
2. To
include in tax treaties a specific anti-abuse rule based on limitation-on-benefits provision which will address a large
number of treaty shopping situations based on legal nature, ownership in, and
general activities of, resident of contracting state
3. To
include in tax treaties a more general anti-abuse rule based on Principal
purpose of transactions or arrangements (Principal Purpose test or PPT)
Limitation-on-Benefits
Background
1. The
benefits under treaty are available to persons who are resident of either of
contracting states involved in treaty.
2. Resident of contracting are defined under treaty to
include person who are liable to taxation therein by reason on domicile, residence,
place of incorporation, place of management or any other criterion of similar
nature.
3. Based
on above- stated residential criterion, it was fairly easy for MNC to satisfy
the residential status in a state and obtain the treaty benefits entitlement to
that state.
4. Action
6 report proposes to insert set of new article in tax treaty to prevent the treaty benefits in
inappropriate cases.
The new of set of Article relating to Limitation-on-benefit is proposed
in 6 paragraphs as under:-
Para -1- Declaration-The benefits under
treaty will be available to residents
who are QUALIFIED RESIDENT at the time
when treaty benefit is being sought, hereinafter referred to as relevant time.
Para 2 – Provide criterion for determination of qualified resident by reference to the nature or attributes of various categories
of various persons. Qualified
resident is entitled to all treaty
benefits.
Para 3 - Treaty Benefit for specific item
of income-It provide that person is entitled to benefit under treaty
with respect to an item of income
even such person in not a qualified resident as per para 2, as long as such
item of income is derived in connection with the active conduct of trade or
business in that person’s state of residence
Para 4 – It provides for derivative benefit rule
that allow companies owned by resident of third states to obtain treaty benefit
provided that these resident would have been entitled to equivalent benefits,
if they had invested directly.
Para 5 – It provides for Discretionary relief ,whereby the Competent authority of a contracting state
is empowered to grant treaty benefits where the other provisions of Article
would otherwise deny these benefits.
Para 6 – Definition clause for the purpose of this Article.
Ø Para 2 – Provides criterion for
Resident to be Qualified Resident for following entities
a) Individual – No specific Criterion,
implying that Resident Individual is Qualified Resident by default.
b) Contracting state or a political
sub-division or local authority thereof or a person that is wholly –owned by
such state, political sub-division or local authority- No Specific
Criterion
c) Listed Company or entity – Specific
Criterion
d) Pension Fund – Specific Criterion
e)
Unlisted
Company or entity- Specific Criterion.
·
Listed
Company or entity
Company or entity which is
resident of Contracting state is qualified resident, if
1. Qualified Residential Status for Holding
company or entity -Throughout the taxable period that includes relevant time,
the principal class of its shares is regularly
traded on one or more recognised stock exchange (as agreed in the treaty)
and either
a) Its
principal class of shares is primarily
traded on one or more recognised stock exchanges located in the contracting
state of which company or entity is resident or
b) The
company’s or entity’s primary place of
management and control is in the resident contracting state
(Hereinafter
referred to as Listed Entity)
OR
2. Qualified Residential Status for Subsidiary
Company or entity -Throughout the taxable period that includes relevant time
, at least 50% of aggregate voting power and value of shares in the company or
entity is owned, directly or indirectly, by listed Companies or entities
(Qualified Resident) referred to in (1) above.
Example –
Suppose Company S, 70% subsidiary of Company H, is incorporated in X Country whose
shares are listed in Y Country. Company H is also listed company and whose
shares are primarily traded in Country X. Now Qualified Residential Status of
Company S in Country is as under:-
a) Company
H is qualified Resident of Country X.
b) Company
S will be qualified Resident of Country X solely on account of more than 50% of
voting power is held by Qualified Resident of Country X.
Words Required Special
importance
a) Regular
Traded
b) Primarily
Traded
c) Primary
place of management and control
Model
Commentary has explained the above-mentioned Words
a)
Regularly
Traded
For shares
are to be considered regularly traded on one or more stock exchange throughout
the taxable period, it is necessary that more than a very small percentage of
the shares be actively traded during a sufficiently large number of days
included in that period.
b)
Primarily
Traded
Principal
class of share is primarily traded on one or more recognise stock exchange
located in the contracting state of which the company or entity is resident if,
during the taxable period, trading of such shares on stock exchange located in
resident contracting state exceeds the trading of such shares on other stock
exchange in any other state.
c)
Primary
place of management and control
The
company’s or entity’s primary place of
management and control is in the resident contracting state if
i)
Executive officers and senior management
employees
ii)
Exercise day-to-day responsibility for
iii)
The strategic, financial and operational policy decision
iv)
More in resident contracting state than in other
state and
v)
The staffs of such person conducts more of
day-to-day activities necessary for preparing and making those decision in
resident contracting than in other state.
The term is
distinguish from place of effective management which was interpreted as the
place where most senior person (Board of Directors) made the key management and
commercial decision necessary for conduct of company’s business.
·
Unlisted
Company or entity
Action Report provides that unlisted
company or entity is to satisfy two tests simultaneously, to enable them to
being Qualified Resident:-
a) Ownership
Test
b) Base
Erosion Test
Ownership test
Unlisted company or entity,
which is resident of contracting state, will be Qualified Resident on the basis
of ownership test upon satisfaction of following conditions:-
i)
On at least half the days of taxable period that include relevant time
ii)
50% or more aggregate voting power and value of
shares are, directly or indirectly,
owned by following qualified resident of
that contacting state:-
a) Individual
b) Contracting
state or a political sub-division or local authority thereof or a person that
is wholly –owned by such state, political sub-division or local authority
c) Pension
Fund
d) Listed
Entity
Example
·
A (P) Ltd is company incorporated in Country X
and its 70% equity shares are held by B (P) Ltd, which is incorporated in
Country Y. The entire equity share capital of B (P) Ltd are held by Individual
who are residents of Country X. In this case A (P) Ltd will be Qualified
Resident based on ownership test, as more than 50% its shares are indirectly
owned by resident Individuals of Country X.
·
A (P) Ltd is company incorporated in Country X
and its equity shareholding are as under:-
Ø 70%
is held by B (P) Ltd, which is incorporated in Country Y
Ø 30%
is held by Individuals who are resident of Country Y
The equity
Shareholding of B (P) Ltd is as under:-
Ø 70%
is held by Individuals who are resident of Country X
Ø 30%
is held by individuals who are resident of Country Y
The
question for consideration is how to determine quantum of Indirectly shareholding
of Individual resident of Country X in A
(P) Ltd
Ø Will
it be 49% (70% of 70%) (70% of shareholding of B, which in itself held 70%
holding is A, is held by resident Individuals of Country X)
Ø Will
be 70% (Since B is holding more than 50% shareholding in A, the shareholding of
B will represent shareholding of A)
OCED or
bilateral negotiation will further provide clarity on determination of indirect
shareholding.
Base Erosion Test
Unlisted company or entity,
which is resident of contracting state, will be Qualified Resident on the basis
of Base Erosion test upon satisfaction of following conditions:-
i)
Less than 50% of Gross Income of taxable period that include relevant time,
determined under tax laws of said company or entity state of residence
iii)
Is paid or accrued to following persons who are not qualified resident of
company or entity resident contacting
state:-
a) Individual
b) Contracting
state or a political sub-division or local authority thereof or a person that
is wholly –owned by such state, political sub-division or local authority
c) Pension
Fund
d) Listed
Companies
ii)
In the form of payments deductible for tax
purpose in said company or entity state
of residence, other than Arm length payment in the ordinary course of business
for services or tangible property.
Example:-
1. Suppose
X Ltd is Resident of Country A and all its shareholding are held by Individuals
who are residents of Country A
2. Gross
Income of X Ltd is 1,00,000 and following deductible payments are to persons
who are residents of Country B
a) 30,000
to P, being at Arm length Price
b) 40,000
to Q, not being at Arm length Price
3. Tests
for X Ltd, to judge Qualified resident of Country A
a) Ownership
Test – Since all shareholders are resident of Country A, ownership test is
being met
b) Base
Erosion Test
i)
70% (70,000) of Gross Income is paid to persons
who are not residents of Country A
ii)
30,000 payments is at Arm Length Price
iii)
Only 40,000 (40% of Gross income) is paid to
persons who are not resident of Country A
iv)
Since less than 50% of Gross Income is
deductible payment, which is made to person who are not residents of Country A,
base erosion test is also met
c) Since
both ownership and base erosion test is met, X ltd is Qualified resident of
Country A.
Clarifications required
Before incorporating the said
clause as per a part of LOB article, contracting states should attempt to
provide clarification on following aspects:-
a) Determination
of Gross Income
i)
Gross income is an accounting concept and taxation
laws of most country provide rules and regulations for determination of taxable
income.
ii)
Whether Gross income is considered at Sale level
or Gross profit level?
b) Time
period for quantification of Deductible payments
Base
erosion test is satisfied when less than 50% of deductible payment of taxable
period that include relevant time, are made to non-qualified residents
i)
Suppose X Ltd, resident of Country A, sought
treaty benefits under treaty between Country A and B on 1/7/2015.
ii)
The taxable period in country A is Financial
Year
iii)
Question for consideration is whether base
erosion test should be tested for last concluded financial year i.e FY 13-14 or
said test should be tested for provisional financials till 1/7/2015.
c) Determination
of Arm Length Price
Arm length
price payment to non-residents are deemed as payment to Resident for evaluating
base erosion test
i)
Will the self-evaluation of Arm length Price by
tested party is sufficient or
ii)
The arm length price be certified by taxation
authority of tested party state of residence
d) Base
erosion test Certification
Who shall
be relevant authority to certify the satisfaction of said test by tested party.
Ø Para 3- Provides for treaty
benefits with respect to an item of income from other contracting state
A resident of contracting
state, whether qualified resident or not as per para 2, is entitled to treaty benefit with respect to item of income
derived from other contracting states, if following conditions are met:-
1. Resident
of Contracting states is engaged in active
conduct of business in that that state.
2. The
nature of business is other than business of making or managing investment for
own account, unless these activities are part of activities of banking,
insurance or securities activities carried out by bank or financial institution
3. The
income is derived from other contracting state in connection with or is incidental
to that business.
4. In
case an item of income derived from other contracting state is from business
activity carried by resident of contracting state or an associated enterprise
of said resident, then business activity carried out in contracting state of
resident must be substantial in
relation to business activities carried out in other contracting state by that
resident or its associate enterprise.
Critical points:
1. The
important point for consideration is that item of income should be derived from
other contracting state, irrespective of how its taxability right is
distributed between contracting state.
2. The
Treaty benefits to an item of income is broadly two fold
a) Concessional
taxation in the state of source
b) Double
taxation avoidance in the state of residence, either under exemption method or
credit method.
It is
assumed that treaty benefit to an item of income includes both concessional
taxation in state of source and double taxation avoidance in state of
residence.
Highlighted words carries special significance and as such explained in
the model commentary
a) Active
Conduct of Business
An entity
will be considered to be engaged in active conduct of business only if persons
through whom entity is acting (such as officers and employees of company)
conduct substantial managerial and operational activities in the resident
state.
b) In
connection with
An item of
income is derived in connection with
business if the income producing activity in the state of source is a line of
business that
i)
Forms a part of
ii)
Is complementary
To the
business conducted in the state of residence by income recipient.
·
Forms
part of
A business
activity in the resident state, generally will be considered to be form part of
business conducted in the state of source if two activities involve
i)
Design , manufacture or sale of same products or
types of products or the provision of similar services
ii)
Thus for same
products or types of products or the provision of similar services, line of
business in the state of residence may be
1) Upstream
– Provide inputs for manufacturing process in the state of source
2) Downstream - Sell the outputs generated from
manufacturing process in the state of source
3) Parallel
– Sell the same sorts of products that
are being sold by the business carried on in the state of source
·
Complementary
For two
activities to be complementary, the activities need not relate to same type of
products or services but
i)
They should be part of same overall industry and
ii)
Be related in the sense that success or failure
of one activity will tend to result in success or failure for the other
c) Incidental
to
An item of
income derived from state of source is incidental to the business carried on in
the state of residence if the production of item facilitates the conduct of
business in the state of residence
d) Substantial
Determination
of substantiality of business in state of residence in comparison with business
in other contracting state shall be based on following factors
i)
Comparative size of business in each contracting
state
ii)
Nature of activities performed in each
contracting state and relative contributions made to business in each
contracting state
iii)
Relative size of economies and markets in two
contracting states
The model commentary has given
various examples to illustrate the above-mentioned terms
Ø Para 4 - It provides for
derivative benefit rule that allow companies owned by resident of third states
to obtain treaty benefit provided that these resident would have been entitled
to equivalent benefits, if they had invested directly
A company which is resident of
contracting state is entitled to treaty benefits, if at the relevant time,
following conditions are met:-
a) At
least 95% of aggregate voting power and value of shares is owned, directly or
indirectly, by 7 or fewer persons that are equivalent beneficiaries and
b) Satisfaction
of Base Erosion test as under
i)
Less than 50% of Gross Income of taxable period that include relevant time,
determined under tax laws of said company or entity state of residence
ii)
Is paid or accrued to equivalent beneficiaries.
iii)
In the form of payments deductible for tax
purpose in said company or entity state
of residence, other than Arm length payment in the ordinary course of business
for services or tangible property
Equivalent beneficiaries
In the concept of equivalent
beneficiary, following contracting states are involved
1. Resident
of Third State (State “T”)
2. Residence
state of Company (state “R) i.e. company for which criterion of Residential
status for treaty benefit is evaluated
3. Source
state (State “S) from which Income would accrue to State R.
The term Equivalent
beneficiary means resident of State T, if either of following conditions are
met:-
Condition 1
Resident of state T is
equivalent beneficiary if
a) Such
resident is either Individual, Contracting state or a political sub-division or
local authority thereof or a person that is wholly -owned by such state,
political sub-division or local authority, pension fund or listed company and
b) It
is entitled to all benefits of treaty
between state T and state S, by virtue of being qualified residents of State T
based on similar conditions of qualified residents containing in the treaty
between State R and State S, such conditions being part of treaty between state
T and State S or if treaty between State T and State S does not have
comprehensive Limitation on benefit article, it is a resident (under Article 4) of either State R or State S and
c) In
respect of income being dividend, interest and Royalty referred to in Article
10,11 & 12, the rate of Tax under treaty between State T and State S is
equal to or lower than rate of tax under treaty between State R and State S.
Condition 2
Resident of State is
equivalent Beneficiary if
a) Such
resident is either Individual, Contracting state or a political sub-division or
local authority thereof or a person that is wholly -owned by such state,
political sub-division or local authority, pension fund or listed company and
b) Is
qualified resident of either state R
or State S
Para 5 – It provides for Discretionary relief ,
whereby the Competent authority of a
contracting state is empowered to grant treaty benefits where the other
provisions of Article would otherwise deny these benefits
Para 5 provides as under:-
a) Where
resident of one of contracting state is not entitled to all benefits of treaty
under para 1 to para 4
b) Such
resident may apply to competent authority of that state to grant benefits
c) In
such scenario, the competent authority may grant these benefits, if after
considering relevant facts of the case, determine that neither establishment,
acquisition nor maintenance of resident, nor conduct of business, had as one of
principal purpose of obtaining benefits under treaty.
Summary
Upon implementation of
Limitation on benefit article in Treaty, a resident of contracting state will
be entitled to treaty benefits on satisfaction of certain conditions, as
under:-
S.No
|
Treaty Benefit
|
Satisfaction of
Condition
|
1.
|
a) All treaty Benefit,
including treaty benefit from item of income in source state not connected
with business in resident state.
b) Income from business of making
investment or managing investments for resident’s own account.
|
Para 2 or Para 4
or Para 5
|
2
|
Treaty benefit on item of
income from source state connected with active conduct of business in
resident state
|
Para 3
|
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