Treaty shopping and BEPS Action 6: An Indian perspective

Abstract

On October 5, 2015, the OECD released its final reports under the base erosion and profit shifting (BEPS) project, which were presented to the G20 finance ministers on October 8 2015. BEPS Action 6 identifies tax treaty abuse and, in particular, treaty shopping, as one of the most significant sources of BEPS concerns. Pritin Kumar, Vishal Palwe and Heta Jhaveri of Deloitte provide an update on action to counter treaty abuse, from an Indian perspective. Over the past few years, the Indian government has been working to tighten the rules in the Indian tax law for granting tax treaty benefits. The government has introduced a requirement for non-residents to furnish a tax residency certificate, along with a self-declaration confirming certain basic information, as a minimum threshold to claim tax treaty benefits. The roll-out of the proposals in the final report under BEPS Action 6 coincides with India's efforts to curb tax treaty shopping. India has been including an anti-abuse rule in its recent tax treaties, but incorporating such a provision in older treaties is likely to take time - one case in point has been India's unsuccessful efforts to renegotiate the tax treaty with Mauritius to include a provision that would deny tax treaty benefits to multinational enterprises that set up conduit companies in Mauritius primarily to take advantage of the capital gains exemption available under the treaty.

On October 5 2015, the OECD released its final reports under the base erosion and profit shifting (BEPS) project, which were presented to the G20 finance ministers on October 8 2015. BEPS Action 6 identifies tax treaty abuse and, in particular, treaty shopping, as one of the most significant sources of BEPS concerns. Pritin Kumar, Vishal Palwe and Heta Jhaveri of Deloitte provide an update on action to counter treaty abuse, from an Indian perspective.

Indian authorities are keen to ensure use of the capital gains tax exemption in the Mauritius treaty is not abused

Over the past few years, the Indian government has been working to tighten the rules in the Indian tax law for granting tax treaty benefits. The government has introduced a requirement for non-residents to furnish a tax residency certificate, along with a self-declaration confirming certain basic information, as a minimum threshold to claim tax treaty benefits. Additionally, in 2012, the government codified certain anti-abuse rules and announced that a general anti-avoidance rule (GAAR) would be introduced into the Indian tax law. The GAAR will empower the tax authorities to deny tax treaty benefits if they find that a transaction was entered into with the sole objective of tax avoidance. The government has also introduced domestic rules that permit it to designate a country or territory as 'blacklisted' due to a lack of an effective exchange of information process; this designation has a number of consequences and may limit the availability of tax treaty benefits. Thus far, the government has identified one country (Cyprus) as a blacklisted country under these provisions.

The roll-out of the proposals in the final report under BEPS Action 6 coincides with India's efforts to curb tax treaty shopping. India has been including an anti-abuse rule in its recent tax treaties, but incorporating such a provision in older treaties is likely to take time - one case in point has been India's unsuccessful efforts to renegotiate the tax treaty with Mauritius to include a provision that would deny tax treaty benefits to multinational enterprises that set up conduit companies in Mauritius primarily to take advantage of the capital gains exemption available under the treaty. The proposals under BEPS Action 6 (combined with those under BEPS Action 15 (developing a multilateral instrument to modify bilateral tax treaties)) may provide an opportunity to amend India's bilateral tax treaties to introduce anti-abuse rules through a single instrument.

BEPS Action 6

BEPS Action 6 targets tax treaty shopping by multinational enterprises that establish 'letterbox', 'shell' or 'conduit' companies in countries with favourable tax treaties - although such companies exist 'on paper', they may have no (or very little) substance in reality and may exist only to take advantage of tax treaty benefits. The final report under Action 6 proposes a minimum set of standard rules to be included in bilateral tax treaties, to effectively address treaty shopping.

The final report proposes that tax treaties should include a clear statement in their title and preamble that the countries entering into the tax treaty intend to avoid creating opportunities for non-taxation (or reduced taxation) through tax evasion or avoidance, including through treaty shopping.

Countries would implement this common objective by including in their treaties:

a combination of a limitation-on-benefits (LOB) rule (a specific anti-abuse rule) and a 'principal purpose test' (PPT) rule (a general anti-abuse rule);

a PPT rule (but no LOB rule); or

An LOB rule supplemented by a mechanism that addresses conduit arrangements, such as a restricted PPT rule applicable to conduit financing arrangements (in which an entity otherwise entitled to treaty benefits acts as a conduit for payments to third-country investors).

The LOB rule targets treaty shopping situations based on the legal nature, ownership and general activities of the company seeking treaty benefits. The PPT rule considers the principal purposes of transactions or arrangements, and targets other forms of treaty abuse and treaty shopping not covered by the LOB rule, such as conduit financing arrangements, among others.

The implementation of the proposals under Action 6 will require an amendment to bilateral tax treaties. Under BEPS Action 15, a multilateral instrument is being developed to be signed by all interested countries that effectively would amend existing tax treaties between such countries to implement measures to combat BEPS. India is among the participants in the group developing the multilateral instrument, which is expected to be ready for signature by December 31 2016.

Anti-abuse rules under domestic law, India's tax treaties and related jurisprudence

GAAR under domestic law

In the 2015 Budget, in light of the continuing work on the BEPS Project (including Action 6), India deferred the implementation of its GAAR provisions to April 1 2017. The government clarified that it intends to implement the GAAR provisions as part of a comprehensive regime to deal with BEPS and aggressive tax planning. It also clarified that investments made up to March 31 2017 will not be subject to the GAAR provisions. The GAAR is expected to be aligned with the proposals under BEPS Action 6, since India is a part of the G20 and is actively involved in the BEPS Project.

The introduction of the GAAR is likely to change the way in which taxpayers are allowed to claim benefits under India's tax treaties. Under the current version of the GAAR, the tax authorities may deny tax treaty benefits to a taxpayer if they find that a transaction was entered into for the sole purpose of obtaining a tax advantage under the tax treaty.

Anti-abuse rules under tax treaties

As things stand, only a few of India's tax treaties feature some sort of anti-abuse rule-including those with Finland, Luxembourg, Malaysia, Norway, Poland, Singapore, the United Arab Emirates, the UK and the US:

The typical approach includes a general anti-abuse rule, under which tax treaty benefits may be denied to a resident of the treaty country if the main purpose, or one of the main purposes, of an arrangement was to obtain tax treaty benefits. The term used for such a provision typically is 'limitation of benefits', but, in essence, the provision is more akin to the PPT rule in the proposals under BEPS Action 6 than an LOB rule.

The approach is completely different in the case of India's tax treaty with the US, which includes a detailed anti-abuse rule based on the US model treaty - this is akin to the LOB rule envisaged in the proposals under BEPS Action 6.

A combination of specific and general anti-abuse rules relating to the capital gains exemption is found in India's tax treaty with Singapore. The capital gains exemption under the treaty may be denied if a company's affairs were arranged with the primary purpose of taking advantage of the exemption. The treaty defines a shell/conduit company and sets forth an objective test for determining whether such a company exists, on the basis of total annual expenditure incurred relating to operations in the country of residence.

In some of India's recent tax treaties (including the treaties with Luxembourg and Malaysia), the LOB clause includes a provision that permits the application of domestic provisions to prevent tax evasion to prevail over the tax treaty in a case of treaty abuse.

Case law relating to anti-abuse rules

The Indian tax authorities and taxpayers have been at odds for a long time when it comes to the applicability of anti-abuse rules to deny tax treaty benefits. The major issue has been the overarching approach of the Indian tax authorities of reading anti-abuse rules into the domestic tax law and relevant tax treaties. This issue has been considered by the Indian courts, which generally have rejected the tax authorities' approach.

"The Indian tax authorities are known to be aggressive in their approach to tax treaty abuse; if they indiscriminately exercise the power to invoke the anti-abuse rules, this may add to the burden of taxpayers"

In a landmark Supreme Court ruling in the 2003 case of Azadi Bachao Andolan, the tax authorities attempted to read an anti-abuse rule into the India-Mauritius tax treaty. They argued that certain offshore companies incorporated in Mauritius were shell companies that carried on no business in Mauritius and were incorporated with the sole motive of taking undue advantage of the capital gains tax exemption available in the India-Mauritius tax treaty. However, the Supreme Court observed that there is no inherent anti-abuse rule (that is, no rule similar to the LOB rule) in the India-Mauritius tax treaty. The court opined that treaty shopping " is a matter which is best left to the discretion of the executive as it is dependent upon several economic and political considerations. This Court cannot judge the legality of treaty shopping merely because one section of thought considers it improper. A holistic view has to be taken to adjudge what is perhaps regarded in contemporary thinking as a necessary evil in a developing economy ". The ruling of the Supreme Court has generally been followed by the Indian courts.

The Indian tax authorities' attempts to apply domestic anti-avoidance rules that are not currently part of the Indian tax law were discredited by the Supreme Court in the 2012 Vodafone case. The Supreme Court noted that taxpayers need certainty as to tax policy if they are to operate efficiently and make rational economic choices, and that certainty also helps the tax authorities enforce the law. The court concluded that it is the government's responsibility to incorporate the relevant anti-abuse rules into the domestic tax law and India's tax treaties, "to avoid conflicting views".

In the 2015 ruling in Baker Hughes, the Delhi Tribunal considered the relevance of BEPS considerations that the revenue authorities argued provided a reason to apply anti-abuse rules. The tribunal explained that BEPS is a tax policy consideration that is relevant for the legislative process, but it cannot have a role in the judicial decision-making process because the judicial process would infringe neutrality if it were swayed by such a policy consideration. The courts must not only be neutral vis-a-vis the parties, they also must be value-neutral vis-a-vis competing ideologies. Judicial authorities must interpret the law as it exists, and not as it ought to be in the light of certain underlying value notions.

Issues to iron out

In the past, Indian courts have struck down attempts by the tax authorities to invoke anti-abuse rules, on the grounds that such rules currently are not provided for under the Indian tax law or the relevant tax treaty. The introduction of GAAR provisions under the Indian tax law, and the adoption of the proposals under BEPS Action 6, will empower the tax authorities to challenge treaty shopping.

"The introduction of GAAR provisions under the Indian tax law, and the adoption of the proposals under BEPS Action 6, will empower the tax authorities to challenge treaty shopping"

However, some uncertainties remain as to how the BEPS proposals would be incorporated into Indian tax law. The proposals under BEPS Action 6 do not represent a consensus view of the OECD and G20 countries involved, and the approach that India will adopt in terms of including an LOB/PPT rule in its bilateral tax treaties may not be clear until the work to develop the multilateral instrument under BEPS Action 15 is concluded in December 2016.

Similarly, it remains to be seen how the Indian GAAR to be introduced will be modified pursuant to BEPS Action 6. The current version of the GAAR provisions contains a 'main purpose test', which is similar to the PPT rule proposed under BEPS Action 6. Such rules are inherently subjective, requiring a case-by-case analysis of whether a transaction or arrangement reasonably can be considered to meet the main or principal purpose test. In contrast, the proposed LOB rule is based on objective criteria that would provide more certainty than the PPT rule.

Once anti-abuse rules officially are adopted, there is likely to be litigation over the issue of applicability of the rules to the particular facts of a case. The Indian tax authorities are known to be aggressive in their approach to tax treaty abuse; if they indiscriminately exercise the power to invoke the anti-abuse rules, this may add to the burden of taxpayers.

Taxpayers will have to evaluate how the introduction of the Indian GAAR and the proposals under BEPS Action 6 may impact their ability to continue to claim benefits under tax treaties. Taxpayers that may be adversely impacted by these developments may wish to start planning to restructure arrangements or to account for the additional tax cost that may arise from a denial of tax treaty benefits.