Monday, August 28, 2006

Treaty Shopping and GAAR: To be or not to be

In late 2004, Canada extended the application of Canada’s general antiavoidance rule (GAAR) to Canada’s tax treaties. Basically, section 245, which contains the GAAR rule, was retroactively amended to make explicit reference to tax treaties Taking into account the uncertainty surrounding the application and compatibility of GAAR in the field of tax treaties, any case-law in this area is helpful, not only to discuss this issues, but also to determine whether GAAR is an effective tool to counter abusive tax Treaty transactions.

In a very recent case decided by the Tax Court of Canada (MIL (Investments) S A v. The Queen), a Luxemburg company was able to claim for an exemption under the previous Canada-Luxembourg income tax treaty on capital gains derived from the sale of shares, notwithstanding the Canadian tax authorities claim that the Canada's GAAR or even an "inherent anti-abuse rule" in the Treaty denied the benefits of the said exemption.

The facts of the case involve a series of (rather complex) transactions, namely (i) the acquisition by a Cayman Islands incorporated company (MIL) of shares of a Canadian company (DFR), (ii) exchange of DFR shares for shares of another Canadian public company (INCO) by MIL reducing the shareholding of MIL in DFR to just less than 10%; (iii) the transfer of the place of effective management of MIL from Cayman to Luxemburg; and (iv) the sale to INCO by MIL of DFR shares, amounting to a sale of shares representing less than 10 percent.

According to Paragraph 4 of Article 13 of the Canada-Luxembourg income tax treaty, capital gains derived by a resident of Luxemburg (MIL) from the alienation of shares (other than shares listed on an approved stock exchange in the other Contracting State) forming part of a substantial interest (i.e. 10% or more) in a Canadian company may be taxed in Canada. Nevertheless, in this case the sale of shares was just below the 10% threshold. As such, paragraph 5 of the same article was applicable, determining that capital gains from the alienation of shares were taxable only in Luxemburg, namely the country where the alienator is a tax resident.

In first place the Canadian tax authorities attempted to apply the Canada's GAAR (i.e. Section 245) in order to deny the treaty exemption. In that regard, the Tax Court made a number of interesting findings in the course of deciding that the GAAR did not apply to deny the treaty exemption.

According to the Court, the application of the Canadian GAAR involves three steps. The first step is to determine whether it is a 'tax benefit' arising from a 'transaction'. The second step is to determine whether the transaction is an avoidance transaction, in the sense of not being 'arranged primarily for bona fide purposes other than to obtain the tax benefit. The third step is to determine whether the avoidance transaction is abusive. All three requirements must be fulfilled before GAAR can be applied to deny a tax benefit.

In this case there was no discussion as to whether the treaty exemption afforded the Luxemburg company a “tax benefit”, but instead whether the transactions taken by the taxpayer qualified as an “avoidance transaction”.

In that regard, the court noted that if there are both tax and non-tax purposes to a transaction, it must be determined whether it was reasonable to conclude that the non-tax purpose was primary. If so, the GAAR cannot be applied to deny the tax benefit. In this case and after careful and long examination, MIL was said to have a bona fide commercial reason for selling the shares.

As to the transfer of place of effective management to Luxemburg, The Court considered that MIL continuance into Luxembourg was commercially justified because it was a better jurisdiction than the Cayman Islands from which to carry on a mining business in Africa and that there was sufficient business presence in Luxemburg to demonstrate that fact.

Having considered that both the sale and underlying transactions were not avoidance transactions, the issue whether any of those transactions was abusive was no longer necessary. Nevertheless, the Tax Court considered whether the tax treaty exemptions relied upon by MIL were abusive in the context of the GAAR.

As regards the choice of Luxemburg as the (new) place of residence of the holding, the court noted that here is nothing inherently proper or improper with selecting one foreign regime over another. The Court stated that, although the selection of a low tax jurisdiction may speak persuasively as evidence of a tax purpose for an alleged avoidance transaction, the shopping or selection of a treaty to minimize tax on its own cannot be viewed as being abusive.

The Court further noted that one must examine the treaty in question and in this case the general rule, contained in Art. 13(5) of the Treaty, is that capital gains on the sale of shares are taxable only in the country in which the taxpayer is resident (i.e. Luxembourg). An exception is only made (allowing Canada also to tax) for capital gain on the sale of shares amounting to a substantial interest (10% or more).

The Court noted that the reliance by MIL (Luxemburg resident company) on the treaty provision agreed upon by both Canada and Luxembourg couldn’t be viewed as being a misuse or abuse. In fact, if Canada concern was directed to the use of preferable tax rates by any of its treaty partners, the Court recommended the (more difficult) option of renegotiate the treaty, instead of attempting to apply the GAAR provision!

The tax authorities presented an alternative line of argumentation that even if the GAAR would not apply to deny the treaty benefit, it is still possible to deny the treaty benefits based on the anti-abuse rule inherent within the Tax Treaty itself. For that purpose, the Canadian Tax Authorities relied on an expert from Luxembourg, namely Prof. Dr. Alain Steichen.

Accordingly, inherent anti-abuse test considers that that a specific Treaty benefit may be denied in situations where both domestic anti-avoidance rules (i.e. Canada and Luxembourg) would deny that benefit. As such, it would be important also to consider the "reversed scenario" in which MIL continued into Canada from the Cayman Islands in order to use the Treaty. In order to establish the inherent anti-abuse rule, reference was made to international legal principles, namely the Vienna Convention on the Law Treaties and the OECD Commentaries.

The expert mentioned that neither Art. 13 nor any other article appears to be providing for a specific anti-treaty shopping provision eventually explicitly authorizing Luxembourg under the reversed scenario to deny the Treaty Benefits under Article 13(5). Only the preamble, which refers to the prevention of fiscal evasion, could be relied upon. Nevertheless, the expert considered that such reference does not constitute an anti-treaty shopping provision on which Luxembourg could rely upon in order to deny Treaty benefits.

When considering the proper Treaty interpretation, the expert mentioned that only in case of ambiguity under the Treaty, one should refer to other principles in international public law to confer the proper meaning of the Treaty. Accordingly, the expert considered that silence in a Treaty equals ambiguity and such ambiguity could be avoided by writing in the Treaty that local GAAR cannot affect the validity of the application of the Treaty. The expert noted that such inclusion would be a clear statement, in which case one would not have to argue about whether that implicit anti-abuse provision exists or not. Furthermore, the tax authorities presented the 2003 revisions to the OECD commentary as support for the existence of an inherent anti-abuse rule in tax treaties.

As regards the inherent anti-abuse rule, the tax court considered the expert’s opinion unconvincing, in light of the OECD commentary and the decision not to include an explicit reference to anti-avoidance rules in the said Treaty. The Tax Court relied on "ordinary meaning" of the Treaty and found no ambiguity in the Treaty permitting it to be construed as containing an inherent anti-abuse rule. In conclusion, the claim of MIL for capital gains exemption under Art. 13(5) of the Canada-Luxembourg Tax Treaty was allowed.

Following the 2003 revisions to the OECD commentary, this case is perhaps one of the first in a series of expected cases (in countries which apply a GAAR or substance-over-form rules) dealing with issue of tax treaties and domestic anti-abuse rules.

It is widely discussed by scholars (without sometimes reaching any meaningful conclusion) whether tax treaties preclude the application of domestic anti-abuse or substance-over-form rules. This problem was further emphasized by 2003 revisions to the OECD Commentaries that support the tax authorities view on the subject. Accordingly, Para. 9.2 of the Commentary on Art. 1 of the OECD Model Tax Convention. states that “(...) the answer to that second question [i.e. whether the provisions of tax conventions may prevent the application of the anti-abuse provisions of domestic law], is that to the extent these anti-avoidance rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability, they are not addressed in tax treaties and are therefore not affected by them.”

Albeit the victory of the taxpayer, this case demonstrates the willingness of tax authorities to push the boundaries of domestic anti-abuse provisions into the sphere of the tax treaties. Now the question is whether Treaty Shopping and GAAR is to stay or not to stay!

Further (recent) reading
(1) Weeghel, S. van, Boer, R. de, Anti-abuse measures and the application of tax treaties in the Netherlands, Bulletin for international taxation, Vol. 60 (2006), no. 8/9 ; p. 358-364

(2) Arnold, B.J., Weeghel, S. van The relationship between tax treaties and domestic anti-abuse measures, In: Tax treaties and domestic law, IBFD, 2006 ; p. 81-120

(3) Matteotti, R., Interpretation of tax treaties and domestic general anti-avoidance rules - a sceptical look at the 2003 update to the OECD commentary, Intertax, Vol. 33 (2005), no. 8/9 ; p. 336-350

(4) Obermair, C. Weninger, P.J. Treaty shopping and domestic GAARs in the light of a recent Austrian decision on Irish IFS companies, Intertax, Vol. 33 (2005), no. 10 ; p. 466-473

(5)Bernstein, J., GAAR and treaty shopping: an international perspective, Tax notes international, 2005, no. 12 ; p. 1107-1110

(6) Arnold, Brian J., “Tax Treaties and Tax Avoidance: The 2003 Revisions to the Commentary to the OECD Model”, 58 Bulletin for International Fiscal Documentation (2004) no. 6, p. 249-252.

(7) Zimmer, F., “Domestic Anti-Avoidance Rules and Tax Treaties – Comment on Brian Arnold’s Article”, 59 Bulletin for International Fiscal Documentation 1 (2005), no. 1, p. 25.

(8) Martín Jiménez, A.J., Domestic anti-abuse rules and double taxation treaties : a Spanish perspective - part I and 2, Bulletin for international fiscal documentation (2002), no. 11 /12; p. 542-553


Thursday, August 24, 2006

IFA 2006: what to expect from this year IFA

With less than one month to the annual meeting of IFA (a congregation of international tax fanatics), which this year is in my adopted town of Amsterdam (relieving me of big trips), it is time to make an overview of the various topics that will be discussed between 17-22 September 2006.

As usual the congress evolves around two plenary sessions (tax consequences of restructuring of indebtedness and attribution of profits to permanent establishments), which are coupled with break out-sessions (related to such topics) and additional seminars on other pre-selected topics.

The first topic is tax consequences of restructuring of indebtedness. This topic, which explores several debt restructuring scenarios originating from situations of corporate distress analyses the tax treatment of different types of work-outs from a comparative perspective. The first session will focus on tax consequences to unrelated creditors and debtors of debt restructurings, while a special breakout session will analyse the situation where debtor and creditor are related parties.

The second topic addresses the already controversial topic of attribution of profits to permanent establishments (PEs) under the OECD Model Tax Convention. In the wake of delays as to the conclusion of the OECD project on attribution of profits to PE’s, the work of IFA gains more importance since from the branch reports it is already visible differences in the approaches and potential implementation issues and difficulties of the so-called authorised OECD Approach. The same topic is followed up in two breakout sessions, one dealing with specific issues concerning the financial service industry and the other focusing on EU/non-discrimination issues.

With respect to the seminars, it should be mentioned that:
- Seminar A will focus on Indirect tax aspects of cross-border services;
- Seminar B will focus on the concepts of “enterprise” and “business” which are used throughout the OECD Model Tax Convention;
- Seminar C will address international cooperation in countering tax avoidance from a policy and administration perspective;
- Seminar D will focus on the effect of regional and global trade agreements on domestic tax law and bilateral tax conventions;
- Seminar E that normally address recent developments in international tax will focus this year on Chinese incentives and the US fight against inversions;
- Seminar F will discuss the need and scope for coordination of tax policies in the EU; and
- Seminar G will address the increasingly important issue of the relationship between tax accounting and commercial accounting.

But this year the IFA is not only two plenary sessions and seminars but also about the launch of the young IFA network (YIN). Having been actively involved in the launch of this idea, I hope this year will be a YIN year for IFA!

For a more complete overview of the congress activities visit the website of the IFA congress.

Tuesday, August 22, 2006

Prize for the best piece of tax legislation

According to a CNN report, US Republican Sen. Charles Grassley of Iowa is hoping to stamp out the sex trade by taxing pimps and prostitutes, then jailing them when they don't pay.

No wonder Jon Stewart's Daily Show mocked perfectly this genuine piece of tax proposal!

Monday, August 21, 2006

Again Agency PEs (but this time Secret Agents)

I am back from vacation (more detail in some days). Meanwhile, in the eve of the 2006 IFA Congress in Amsterdam, where the topic of the Attribution of Profits to a Permanent Establishment will be thoroughly discussed, the highly recognized Richard J. Vann made available a paper on the (secret) topic of agency permanent establishment (PE) under tax treaties. As you may have noticed (by the old enteries) this topic is dear to me and it is with pleasure that I post the link to the paper at the same time I will print it for the first time and read it! Probably the readers of Talk Tax will expect a comment on the paper in the coming week and I will do the utmost to fulfil such expectation.

In the meantime, here is the abstract to the paper Tax Treaties: The Secret Agent's Secrets also published in the last number of the British Tax Review (No. 3, p. 345, 2006)

Recently two apparent paradoxes have been revealed about an agency permanent establishment (PE) under tax treaties, first that it is possible to avoid an agency PE by exploiting a difference between civil law and common law on agency (often referred to as commissionnaire structures) and secondly that if the agent is rewarded with a market-value fee there will be no profits to attribute to an agency PE. This article demonstrates that these problems have been present since the origin of tax treaties, and that they stem from a form-over-substance approach to PE tests which relegates the independence test in defining PEs to a secondary role, from the use of a different indeterminate independence test in transfer-pricing rules and from the definition of the firm in terms of common ownership. Underlying the problems have been inconsistent views on how value is generated within a firm. The solution is to settle on a workable theory of value, to apply substance over form, and to realise the significance of independence in defining the boundary of the firm. Under current treaty law, the second asserted paradox is not correct if treaties are interpreted in a sensible manner.