Nowhere to Hide

By Lisa Brunton, Senior Legal and Tax Officer, Oasis Group (01/04/2018)

In June 2017, 68 jurisdictions signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (BEPS) (MLI), which was formulated by the Organisation for Economic Co-operation and Development (OECD) in accordance with BEPS Action 15 of the G20/OECD BEPS Project. To date, the number of signatories to the MLI has increased to 71, and several other jurisdictions have expressed their intention to sign in the near future, amongst them, Panama. The signing ceremony in Paris marked yet another significant milestone in the G20/OECD BEPS project, particularly with respect to the implementation of the treaty-related BEPS minimum standards. Given the prevailing dire international landscape, characterised by extremist ideologies; divisive political buffoonery; corruption; mass displacement; poverty and war; the collaborative signing and willingness to adhere to the measures of the MLI by so many countries across the globe, is nothing short of miraculous. This feat notwithstanding, critical questions remain – once ratified, how effective will the MLI prove to be; and which taxpayers will be most impacted by its implementation?

At the time of signature, signatories submitted a list of the operative tax treaties that they wish to designate as Covered Tax Agreements (CTAs). CTAs are to be amended through the MLI. However, the MLI will not operate in the same manner as an amending protocol to an existing treaty, nor will it directly amend the provisions of existing bilateral treaties. Rather, it will apply alongside the existing treaties - the objective being that a signatory to the MLI will be able to update and amend its suite of treaties through a single act, without having to renegotiate each of its treaties individually.

At this stage, it is anticipated that over 1,100 tax treaties will be modified based on matching the specific provisions that jurisdictions wish to add or change within the CTAs nominated by the signatories. The expectation that 1, 100 tax treaties will be modified as a result of 68 jurisdictions signing the MLI constitutes an unprecedented moment in international taxation. It is indicative of the global determination to cooperate on corporate taxation with a view to minimising base erosion while simultaneously striving to eliminate economically harmful double taxation.

 In consequence of the potentially vast range of application of the MLI; it has to be flexible enough to effect amendments to over 3,000 treaties (assuming more signatories to the MLI in the future)  based on different treaty models, some containing certain amending provisions already (e.g. an arbitration clause), of varying scope and age, some with protocols, in a variety of languages, and between countries that have different views on just how much and which parts of the BEPS agenda they want to implement. This is no mean drafting feat!

There are those who hold the view that the OECD is diverging from its founding aims (of increasing wealth through trade; achieving the highest sustainable economic growth and employment; and contributing to sound economic expansion) through the BEPS Project by requiring multi-national enterprises (MNEs) to pay more tax, thereby inhibiting free trade and adversely impacting job creation. I beg to differ. The BEPS Project seeks to ensure that MNEs pay their due (no more, no less) in the jurisdictions where they create value. One may argue that this is an example of the tax principle of taxing in accordance with the ability to pay, coupled with a prohibition on MNEs from arbitraging the discrepancies and interpretational loopholes between various tax regimes to the detriment of other taxpayers in the affected jurisdictions.

Could this be the imposition of a form of corporate international tax morality? If so, legislation of this ilk seems to be trending nationally too. The UK’s Criminal Finances Act 2016, which came into effect in September 2017, has introduced new criminal offences that apply to corporates (and partnerships) which fail to prevent their associated persons from criminally facilitating UK or foreign tax evasion. If an instance of facilitation of tax evasion is identified as having occurred at a corporate; the only defence that corporate can claim against being criminally liable for failing to prevent it, is that it had reasonable procedures (e.g. risk assessment; proportionality of risk-based prevention procedures; top-level commitment; due diligence; communication; training; monitoring and review) in place to prevent the tax evasion. 

Continuing in this vein, the MLI raises the bar internationally, by including a set of minimum standards that all participating jurisdictions have agreed to implement, namely rules dealing with hybrid mismatches; treaty abuse; permanent establishments (PEs) and dispute resolution.

With regard to hybrid mismatches, the MLI provides recommendations to address hybrid scenarios arising from differences in the tax classification of an entity under the domestic laws of two or more jurisdictions that could result in tax benefits (e.g. double non-taxation).

Since treaty abuse has been identified as a significant source of BEPS, the MLI provides various approaches to achieve the minimum standard in this regard. The principal purpose test (PPT) operates to deny treaty benefits in situations where one of the main objectives of an arrangement is to obtain treaty benefits. Alternative remedial options include the adoption of a simplified limitation on benefits (LOB) clause, or a combination of a detailed LOB clause and either specific rules to address conduit financing structures or a PPT.

Most countries adopting the MLI to amend their CTAs have opted for the PPT. Many jurisdictions have a provision similar to the PPT in their domestic law, commonly known as a ‘General Anti-Avoidance Rule’ (GAAR). GAAR operates to deny a tax advantage in circumstances where it is established that securing the tax benefit was the primary purpose of the transaction. The application of GAAR is not without incident. Its application has been likened to a cross-eyed javelin thrower competing at the Olympics – he may not win but he will keep everyone on the edge of their seats. This analogy graphically illustrates the uncertainty surrounding the application of GAAR and begs the question whether the application of the PPT in the international domain will fare any better than its domestic counterpart?

Specific provisions of the MLI, such as the extension of the scope of the dependent agent test and the curtailment of the existing exemptions from PE status, will lower the PE threshold considerably. The provisions also recommend an anti-fragmentation rule designed to prevent the splitting of activities across separate legal entities to circumvent PE status.

In this regard, while the BEPS measures are aimed at businesses that use the internet as their primary sales medium; or that have strongly international and centralised value chains distributing consumer goods or industrial products; and were formulated with the objective of targeting the tax-motivated activities of large MNEs with internet-based core businesses; the measures are broad enough to affect other taxpayers. The asset management industry may be affected. Unfortunately, the MLI does not incorporate any of the OECD 2010 Collective Investment Vehicles (CIV) Report recommendations, an omission that was flagged in the 2015 consultation discussion draft, but appears to have dropped off the MLI radar. This exacerbates uncertainty regarding tax treaty entitlement for CIVs and non-CIVs, which is regrettable, particularly given the prevailing accelerated flight to quality, the investment phenomenon that seems to have become the norm in these tumultuous times. Fund managers should lobby for greater certainty in this regard, which may enhance investment flows into their funds, as investors scramble for safe, liquid assets housed in the safest possible investment vehicles.

Another potentially adverse consequence for the asset management industry may be the curtailment of existing exemptions from PE status. Certain activities, which previously did not create a PE in a particular jurisdiction may now result in the establishment of a PE in such a jurisdiction.   

In closing, as part of the options contained in the MLI, jurisdictions can opt into mandatory binding treaty arbitration (MBTA), an element of BEPS Action 14 on dispute resolution. Unlike the other articles of the MLI, Part VI of the MLI applies only between jurisdictions that expressly choose to apply MBTA with respect to their treaties. Of the 68 countries that first signed the MLI, 25 opted in for MBTA. 

The MBTA provision will apply to all cases of taxation contrary to the relevant treaty, unless a country has made a reservation specifying a more limited scope. The MLI provides flexibility for jurisdictions to agree bilaterally on the mode of application of the MBTA, including the form of arbitration. However, the default rules defined in the MLI will apply in the absence of agreement having been reached by countries before a case materializes that is eligible for arbitration. For those jurisdictions that elect to implement MBTA through the MLI, the MLI provisions will apply to all treaties that do not have such a provision, or instead of existing provisions that provide for MBTA. However, countries may reserve the right not to apply the MBTA provision of the MLI to some or all of their treaties that already embody a MBTA provision.

The inventory of unresolved mutual agreement procedure (MAP) cases has increased significantly over the past several years. This is due in part to the fact that the MAP process does not always function effectively and further, fails to provide enforcement mechanisms. It is anticipated that in consequence of the implementation of the BEPS recommendations, the number of MAP cases will increase even more in the future. The OECD acknowledged this back in 2015 and proposed the development of MBTA provisions as part of the MLI, as a method of resolving the gridlock. This notwithstanding, MBTA has not been elevated to a minimum standard.

The MBTA rules allow a person to request arbitration if the competent authorities have not been able to reach an agreement under a MAP within two years. The competent authorities may agree on a shorter or longer period to resolve a particular case through a MAP provided they notify the affected person before the expiration of the two-year period. In addition, jurisdictions that subscribe to MBTA rules are able to make a reservation and substitute the two-year period with a three-year period in all their treaties.

Should a country fail to make a specific reservation with respect to the scope of the cases eligible for arbitration, all treaty related disputes that could not be resolved through MAP could potentially be subject to arbitration.

The competent authorities of jurisdictions that have implemented MBTA in their treaties are required to agree on its mode of application, including the minimum information necessary for accepting a case for substantive consideration, before the date on which unresolved issues under MAP become eligible for arbitration. Such agreement must include the default rules provided by the MLI itself, such as on the appointment of arbitrators. Further, the OECD is expected to release a model competent authority agreement that will serve as the basis for the procedural arbitration rules. The default rules are meant to ensure that the absence of such rules does not delay the arbitration process for cases that would be eligible for arbitration. As such, the competent authorities are at liberty to deviate from the default rules as they see fit.

The MLI sets out default rules for the composition of an arbitration panel and the appointment and qualifications of arbitrators. Under such rules, the arbitration panel is composed of three independent individual members. Each competent authority appoints a member and those two members then appoint a third member who is not a national or resident of either country to chair the arbitration panel.

Under the MLI provisions, jurisdictions are required to bear the cost incurred in connection with the arbitration proceedings. The MLI also contains rules to ensure that any information shared with the arbitration panel and its staff, remains confidential. Also, the competent authorities may require that each taxpayer, and its advisers, agree in writing that none of the information received from the competent authorities or the arbitration panel during the arbitration proceedings is made public.

As regards the type of arbitration process, the MLI provides for 'final offer' arbitration as the default arbitration process. Under final offer arbitration, each competent authority is required to submit a proposed resolution addressing all the issues under review. The proposed resolution must address each adjustment in the case that has been brought to arbitration and is required to include the allocation of monetary amounts (income or expenses) or a maximum tax rate to be charged under the relevant treaty. The competent authorities are allowed to propose alternative resolutions contingent upon the resolution of underlying questions, such as the existence of a PE or the determination of a taxpayer’s residence under the relevant treaty. Supporting position papers may be submitted, as well as reply submissions to the proposed resolution of the other competent authority. Under 'final offer' proceedings, the arbitration panel selects one of the proposed resolutions as its decision, for which decision it is not required to provide any rationale.

Jurisdictions are entitled to make a reservation on the 'final offer' type of arbitration proceedings and instead, opt for 'independent opinion' proceedings. Under the latter approach, each competent authority provides all necessary information to the arbitration panel. The arbitration panel then decides the case by applying the provisions of the relevant treaty; subject always to the applicable domestic provisions of the treaty partners. Decisions formulated under 'independent opinion' proceedings must indicate the sources of law relied upon and the reasoning applied.

Under both types of arbitration proceedings, the ultimate decision must be adopted by simple majority. Such decision does not carry precedential value.

As stated at the outset, the MLI constitutes an unprecedented change in international taxation, which will indubitably impact significantly on the taxation of MNEs. The OECD has predicted that the first impact on multinational group tax structures will probably occur by 2018 as companies prepare for new treaty provisions a year or two later. In addition, it is anticipated that a few countries will ratify the MLI this year, and that for most jurisdictions, actual changes to treaties will take effect in 2019 or 2020. The litmus test of the MLI's efficacy will be the inter-jurisdictional operation of its provisions alongside the signatories' CTAs. The extensive engagement and consultation by the OECD with its Members, non-members, developed and developing countries; has resulted in the jurisprudential feat that is the MLI. One can only hope that the MLI will be activated with the same dedication and collaborative determination to cooperate on corporate taxation that characterised its formulation. If the MLI works, there will be nowhere to hide.

Lisa Brunton


LLB B Comm Honours Taxation LLM