Anti­Avoidance and Tax Treaties

affiliate. Furthermore, if a significant proportion of such services is provided to unrelated third parties, for example by using pooling arrangements, then the `captive ¶ could be regarded as carrying on an independent insurance or banking business, and therefore fall outside the CFC net US Treasury 1981, p.89. Furthermore, parent companies may derive direct benefit, by `secondary sheltering ¶ of tax­exempt income. The simplest method is for the subsidiary carrying on the CFC­exempt business in a low­tax country to make loans to the parent, or to other affiliates. Such an `upstream loan ¶ is not taxed as income to the recipient as a dividend would be, and indeed the interest payments on the `loan ¶are normally tax deductible by the `borrower ¶ This was described as `a rather naive and straightforward form of tax avoidance ¶ by the OECD Fiscal Committee OECD 1987A­II para. 72; but although some countries such as the US have provisions to tax such loans in some circumstances, others have found it more difficult to counteract. In the UK, the Revenue was forced to withdraw its proposals on upstream loans, following criticism, especially that it would interfere with the carrying out of the central treasury function of multinational company groups based in the UK, which might therefore move this function, and the important associated investments, elsewhere IFS 1982, p.31.

2. Anti­Avoidance and Tax Treaties

The development of measures against tax havens and intermediary companies has important international implications. Such measures necessarily entail the interaction of laws and jurisdictions of the states involved, and of domestic tax laws and treaty provisions. We have seen that, although both the use of general anti­avoidance provisions and the enactment of specific measures against CFCs have been done by countries under their own national laws, they have exercised their sovereignty with some caution, aware of the difficult issues of tax jurisdiction involved. The jurisdiction issue was most immediately expressed by objections from taxpayer groups see Chapter 11 section 1 for a further discussion of tax jurisdiction. Consequently, the measures have been carefully defined, as we have seen: first, to establish an effective connection with the taxing country based on the residence of the shareholders controlling the CFC; and secondly, to target income which but for the interposition of the intermediary company would have accrued to its shareholders. Not surprisingly, these measures have also raised a number of issues for negotiation between states. Since international tax arrangements are based on the network of bilateral tax treaties, these issues have focussed on the negotiation or application of tax treaty provisions. Countries taking measures against international avoidance must consider carefully the implications of such measures both for their existing treaties, and for the possibility of concluding further treaties. It may be that targeting a country as a haven and applying unilateral measures to tax intermediary companies resident there, would preclude the possibility of a more cooperative relationship with the putative haven, based on a treaty or other arrangement. Alternatively, the development of national measures can occur in parallel with negotiations with a haven country, aimed at inducing it to change its own laws to limit its use as a haven, as well as to agree suitable treaty arrangements. Thus, for example, at the time of the German Tax Havens study initiated in 1962, the concern in both West Germany and France over the growth of holding companies created pressure on Switzerland to limit the use of Swiss law for both Base and Conduit companies, and to negotiate new tax treaties with anti­avoidance provisions. The Swiss government went some way to meeting these concerns, by issuing a Decree in 1962 on improper use of tax treaties based on the principle of `abus de droit ¶Switzerland 1962 , followed by administrative regulations which limited the exemption from federal tax for foreign­source income to defined non­abusive situations. However, this did not affect cantonal taxes, and the Swiss tax on a base or conduit company with foreign income from a treaty country remained effectively only 5. Eventually, treaties were signed with France 1966 and Germany 1971 which incorporated anti­abuse provisions based on the 1962 Swiss decree. The treaties went further, however, and excluded from relief on withholding taxes for interest and royalties but not dividends any Swiss company with substantial non­ resident participation, unless it is subject to cantonal profits taxes. 1 Thus, the treaty negotiations and the domestic legislative processes in both sets of countries mutually influenced each other; although the overall process cannot be said to have been a harmonious one, nor to have produced results which adequately satisfied any of the parties. On the international plane, this process has shown up the limitations of the bilateral treaty network, which bears the burden of attempts to coordinate different national approaches to equity in the taxation of international business see Chapter 1 section 4 above. We have seen that a degree of reciprocal advantage is necessary for two countries to negotiate such an agreement. A small country with an underdeveloped economy, exporting no capital, and perhaps having little prospect of attracting inward investment, may prefer to have no treaties. Hence, it may be tempted to become an offshore financial centre and a tax haven. Other countries, such as Switzerland or Luxembourg, have some well­developed industries including some major global TNCs, but also have a substantial banking and financial services sector. These countries have been willing to conclude treaties, but have argued strongly for provisions which put minimal restraint on international capital movements. In their own way, they too became tax havens. Even the UK, which seeks to preserve the City of London as a financial centre, has refrained from measures such as provisions against upstream loans for that reason. 1 See Knechtle 1979, 119­122; OECD 1987A­III Annex II, citing Article 23 of the German­Swiss treaty. Note that this article also explicitly permits the parties to take their own measures against abuse of tax relief on withholding taxes. In the simplified model of international avoidance using intermediary companies outlined in Chapter 6 section 4, we saw that a Parent company in the Residence country can use holding company or service company subsidiaries in Base­Havens, as well as conduits in Treaty­Havens, as intermediaries for activities carried out by Operating subsidiaries in Source countries see Diagram 1. Some havens may fulfil both Base and Conduit functions, but it is convenient to separate the two functions analytically. Thus, measures against international avoidance take the form of anti­ base provisions and anti­conduit provisions. In both these cases, the enacting country must consider not only the compatibility of the measures with existing tax treaties, but their implications for revisions which may be desired or new treaties which could be negotiated. Thus, the anti­avoidance measures must be either broadly, or even specifically, acceptable as legitimate by a range of actual or potential treaty partners. This was recognised by the OECD Fiscal Committee, when it examined the tax treaty implications of anti­avoidance measures OECD 1987A­II and 1987A­III. The Committee had to contend with the view, expressed by Switzerland, that anti­ avoidance measures are contrary to the existing OECD model treaty, and therefore cannot be enforced without agreement with treaty partners and specific incorporation in treaties OECD 1987A­II, paras. 95­7. The Swiss view was that, since tax treaties define and allocate rights to tax, a Residence country cannot use anti­avoidance rules to tax the undistributed income of a Base company validly incorporated in a treaty­ partner state, unless the treaty specifically recognises the applicability of those rules. The large majority of OECD members took the contrary view, that national anti­ avoidance rules were not incompatible with the spirit of the OECD model treaty ibid. para. 40. However, especially in the case of specific anti­avoidance measures such as taxation of CFCs, the Committee considered that counteracting measures should conform to some general principles. Although no clear­cut rules could easily be laid down, the Committee concluded: An international consensus should be established, to which States newly introducing counteracting measures might refer. In this respect, the OECD Committee on Fiscal Affairs ...would... appear to constitute the appropriate forum for the discussion of such policy issues ibid. para 48. This view means at least that a state wishing to take anti­avoidance measures under its own domestic law may go ahead and do so. However, such measures should comply with the broad international consensus of acceptability referred to by the Committee. In addition, they must be tailored to the specific provisions of tax treaties, either in existence or to be negotiated. We will consider compatibility both with general principles and specific provisions, in relation first to anti­base and then to anti­conduit measures. 2.a Anti­Base Provisions Intermediary base companies do not directly take advantage of the relief from double taxation provided by treaties, but exploit the possibilities for deferral offered by the limits on the tax jurisdiction of the country of Residence. Hence, a Base company may be set up in a country which has no tax treaties. Nevertheless, anti­base measures have implications for the Residence states tax treaties with third countries: either with a Source country, or another Residence state. In addition, some countries with existing treaties may be tempted to develop offshore business and become Base­ Havens also; or a Residence state may wish to try to conclude a treaty with a Base­ Haven, and in such cases it is important that its anti­base provisions be defensible and compatible with negotiable variations of the model treaty. The legitimacy of taxation of base company income focuses on two arguments: i that base companies formed in the haven are being used to shelter investment income which has no valid connection with the haven; and ii that they are used not only for illegitimate avoidance but also illegal evasion: they may conceal either income which is fraudulently evading tax, or which has been illegally earned, perhaps from narcotic drug smuggling or other forms of organised crime or both. The two arguments overlap, since the authorities in the taxing countries argue that by offering facilities for the illegitimate concealment of income from taxation, havens are encouraging illegality and turning themselves into shelters for criminals. On the other hand, havens try to keep the two issues separate: they defend the legitimacy of international tax avoidance in the name of freedom of movement of capital, and try to draw a strict line between such avoidance and tax fraud. This debate is most intense in relation to the attempt to develop international cooperation in tax enforcement, which will be considered below Chapter 10. The point to be noted here is that the states asserting jurisdiction to tax foreign retained income of their residents must do so on a basis that can generally be accepted as valid, if they are to secure cooperation and avoid a variety of difficulties. Three broad principles emerged from the OECD Committees report which considered anti­base measures. Generally, anti­avoidance measures should be used only `to maintain equity and neutrality of national tax laws in an international environment ¶ Therefore, i they should target only income that is genuinely passive income, and should not extend to `activities such as production, normal rendering of services or trading by companies engaged in real industrial or commercial activity; ii they should be aimed at base companies benefiting from low tax privileges and `not be applied to countries in which taxation is comparable to that of the country of residence of the taxpayer ¶ibid. para. 47; iii the counteracting measures should not normally treat the base company as non­existent ibid. para 34. These three principles generally reflect the limits which countries enacting anti­CFC rules have accepted. In particular, the bar against treating as non­existent a company validly created under the laws of another country coincides, as we have seen, with the view often taken by the authorities and courts in the countries enforcing anti­avoidance measures. The particular legal form taken by the anti­avoidance measures may, however, have considerable implications. Although R cannot ignore the existence of B, it might treat B as a resident of R and therefore directly liable to Rs taxes; but if there is a treaty between R and H, the place of residence would have to be established under the Treaty rule of residence: the OECD model Article 4.3 lays down that in cases of conflict the principle of `place of effective management ¶ must be applied. Furthermore, if the anti­avoidance provisions of R take the form of treating B as a resident of R, this would entail giving B the right to protection and benefits under a treaty if one exists between R and S, since under such a treaty residence normally depends on the law of R. This is important, since although B may have been established in a country without treaties, it is much more likely that there would be a treaty between R and S, and the benefits might be considerable reduced withholding taxes on payments from O to B, and a credit in R for taxes paid to S. These implications can be avoided, however, since usually the specific measures against CFCs do not treat the CFC as resident in R, but merely deem its income to be attributable to its controlling shareholders P. Nevertheless, the view taken by most OECD members is that where R has taxed income derived from country S in the hands of P, R should allow a credit for taxes paid to S, in order to `comply with the spirit of international law by seeking to avoid double taxation ¶ ibid. para. 57. However, if R adopts the approach of attribution of Bs income to P, it does not entitle B to the benefits conceded by S under any treaty with R; furthermore, S is not likely to take a generous view and concede any adjustments ibid. para. 59. Finally, questions of compatibility and coordination may arise between two Residence countries which each enforce anti­base measures, since conflicting jurisdictional claims may arise. For example, as mentioned in Chapter 5 section 3 above, if a US parent company shelters the sales of its German manufacturing subsidiary in a Swiss base company, both US and German anti­avoidance provisions may be used to bring the profits retained in the Swiss affiliate within their respective tax nets. In such a situation, there is likely to be a bilateral treaty in force between the two Residence countries, but the view of those countries with CFC provisions is that, in the absence of any specific clause in this treaty, both are entitled to apply their measures to the Base company OECD 1987­B para. 65. However, the taxpayer may ask for elimination of the double taxation thus generated, under the competent authority mutual agreement provisions of the treaty Arts.92 and 25: see Chapter 10.3 below. However, these provisions were not designed to deal with this problem, and are not adequate to do so. If both Residence countries treat the intermediary B as a resident, then it would be directly subject to double taxation, and since B has been treated as a resident it could invoke the mutual agreement procedure Article 25. As we have seen however, most CFC laws tax the shareholder companies resident in R on income deemed to arise to them from B. In such circumstances, the mutual agreement procedure of Article 251 would not apply; a related procedure for competent authorities to consult over pricing between related enterprises is provided for in Article 92, but a number of states do not accept this article, and in any case it deals with the adjustment of transfer prices in transactions between associated enterprises. Nevertheless, the arrangements for Simultaneous Examination of related companies, which have been set up by a number of the main OECD countries, could include consideration of adjustments between two Residence countries see further Chapter 10 section 2c below. The possibility of using the corresponding adjustment procedure in such cases is alluded to in the OECD Base Companies report OECD 1987A­II, paras.39, 65­66; but the report recommends that the matter be dealt with by the inclusion of specific clauses in treaties, such as the one between Canada and West Germany, which requires the state of which the `controlling shareholder ¶ is resident to give credit for the anti­base tax of the other state ibid. para 66. This gives priority to the residence country of a regional parent, and residual rights to the ultimate parents country of residence. 2.b Anti­Conduit Provisions Conduit companies, as we have seen, are set up in countries which have a convenient network of tax treaties, to take advantage of the reduced withholding taxes on payments of dividends, interest and fees and royalties which treaties provide. Since the conduit is not the ultimate recipient of such income, but has merely been established in country T­H to take advantage of treaty benefits, this device is regarded as `treaty shopping ¶ From the point of view of the Source country, it entails an improper advantage being taken by third parties of treaty benefits which were intended to be granted to bona fide residents of the treaty partner state Rosenbloom Langbein 1981, 396­7; Rosenbloom 1983. i Denial of Benefits under Tax Treaties Denial of treaty benefits to companies resident in treaty countries necessarily entails an interaction between any measures taken under the domestic law of S and the provisions of the treaty between S and T­H. Tax treaties are normally incorporated directly or indirectly into national law; so if S wishes to deny a treaty benefit a resident, O, it would entail changing domestic law explicitly to override the treaty provisions see Chapter 11 section 2 below. However, relief can be denied to O if C can be considered not a valid beneficiary of the treaty. As with anti­base provisions, S cannot normally ignore the existence of C if it is a company validly formed under the laws of T­H; however, S may consider that C is not entitled to treaty benefits because it is not a bona fide resident of T­H or not the genuine recipient of the payments entitled to exemption. This may be justified by the provision of Article 4.1 of the model treaty, which excludes from the term `resident of a Contracting State ¶ any person `liable to tax in that state in respect only of income from sources in that state or capital situated therein ¶ However, it seems that this provision was introduced in the 1977 model for a limited purpose, since the Commentary gives the example of diplomatic personnel; it would be a very far­reaching exclusion to deny treaty benefits to all residents of countries which tax only domestic source income OECD 1987A­III, para. 14. It does seem, however, that the question of the abuse of treaty limitations on withholding tax by conduit arrangements was raised in the drafting of the 1977 OECD model. Articles 10, 11 and 12, which deal with restrictions on source taxation of dividends, interest and royalties, each specifically state that the reduced withholding tax only applies `if the recipient is the beneficial owner of the dividends ¶ The Commentary indicates that this excludes cases where `an agent or nominee is interposed between the beneficiary and the payer ¶ The exclusion seems intended to apply, for example, to holdings of shares or bonds by Swiss banks on a nominee basis for clients. However, the OECD Model provides no further asistance: the Commentary merely adds that `States which wish to make this more explicit are free to do so during bilateral negotiations ¶ As the 1987 Report comments, `Opinions may differ as to whether the absence of an overall solution to the conduit problem was at the time a serious flaw in the 1977 OECD Model ¶OECD 1987A­III, para 16. This failure or flaw can be traced, once again, to the disagreements about international tax equity and the limited nature of the solutions inherent in the bilateral treaty model. We have seen that withholding taxes on payments to non­residents, and their limitation on a reciprocal basis by treaty, were the key to reconciling residence and source taxation Chapter 2 above. From the point of view of the Source country, withholding taxes ensure capital­import equity: i.e. that investors from abroad are not taxed more lightly than domestic investors and taxpayers. Thus, even the US has had a withholding tax on all payments to non­residents since 1936 initially at 10, and since the War at a flat rate of 30. However, the tax treaties which were negotiated in the immediate postwar period between the main capitalist countries limited withholding tax rates to low or zero rates, on a reciprocal basis, with the aim of encouraging international investment flows. The OECD Model recommended a maximum of 15 for dividends ­ or 5 if paid to an affiliate ­ 10 for interest, and zero for royalties. In fact, many states have agreed lower rates: the US, for instance, negotiated an exemption for interest paid to residents of many of its treaty partner states, in order to attract private investment into the US. However, some countries which signed treaties agreeing low or zero withholding tax rates did not apply any significant taxes themselves to such foreign­source income: notably Switzerland and Luxembourg. Both they, and other countries which wished to encourage financial business, such as the Netherlands, allowed or facilitated the setting up of holding companies, which could take advantage of the `participation exemption ¶ for dividends received from an affiliate. Then, as we have seen, the expansion of offshore finance during the 1960s spread to other countries, which had even more incentive to become tax havens. Some of these were former colonies, and inherited tax treaties which had been extended to them by agreement between their mother country and the treaty partner. Thus, the USA in 1955 had agreed to the extension of its treaty with the Netherlands to the Netherlands Antilles; and in 1958 the US­UK treaty of 1945 was extended to 20 British overseas territories. These included several in the Carribbean, such as the British Virgin Islands and Barbados, which later adjusted their internal laws to take advantage of the treaties, to attract holding companies which could perform a base andor conduit function in relation to the US US Treasury 1981, pp.149­52. 1 Nevertheless, the wording of the treaty provisions based on articles 4 and 10­12 of the OECD model certainly provided support for any source state wishing to deny treaty benefits to Conduit companies. This could be done unilaterally, simply by refusing treaty relief and applying the full withholding tax in suspect cases. Such action was upheld by the US Tax Court in a case Aiken Industries Inc. v. Commr. 1971 in which promissory notes of a US company to a Bahamian affiliate were transferred to a newly formed Honduran affiliate in exchange for its own notes bearing the same interest rate. The court held that the Bahamian company was not entitled to treaty relief since it was not the `recipient ¶of the interest. On the other hand, as we have already seen, courts may be reluctant to ignore the existence as a separate entity of the Conduit Perry R. Bass v. Commr. 1968, and especially in cases where the conduit receives dividends, it is hard to treat it as a mere nominee if it has no legal obligation to pass on revenue received to a beneficial owner. Another 1 The full list of British territories benefiting from the extension to them of the US treaty was Aden, Antigua, Barbados, British Honduras, British Virgin Islands, Cyprus, Dominica, The Falkland Islands, Gambia, Grenada, Jamaica, Montserrat, Nigeria, Rhodesia Nyasaland, St Christopher, Nevis Anguilla, St Lucia, St Vincent, Seychelles, Sierra Leone and Trinidad Tobago: see US­UK Exchange of Notes of 19 August 1957 and 3rd December 1958; the US ended these extensions by notice taking effect from 1984: see section 3.b below. In addition to the US, Denmark, Norway, Sweden and Switzerland also accepted the extension of their tax treaty with the UK to British dependent and associated states. The list of territories covered in each case was similar but not identical to that of the US, but these extensions established some treaty links which offered avoidance opportunities, e.g. Switzerland­British Virgin Islands: Davies 1985, p.221­2. Although the UKs newer tax treaties do not normally contain a territorial extension article, those previous extensions have been expressly retained, and depending on the state succession practice adopted by each territory, might also continue in force after such a territory attained independence. Britain also accepted the extension of its treaties to the dependent territories of other states: in particular the UK­Netherlands Exchange of Notes of 13 and 29 July 1955 extending to the Netherlands Antilles the treaty of 1948; replaced by the Exchange of Notes of 24.7.1970 extending the new UK­Netherlands treaty of 1967; this was abrogated in respect of the Netherlands Antilles by the UK in 1989, see below. The only other extensions accepted by the UK have been UK­Denmark to the Faroe Islands; and UK­South Africa to Namibia: Davies 1985, p.222. example is where an insurance premium is exempt from excise tax because it is paid to a resident in a treaty country, but the risk is reinsured perhaps on a pooled basis with a company in a low­tax non­treaty state. Furthermore, there are considerable administrative difficulties involved in distinguishing a conduit from a genuine recipient. The Gordon report stated: `In 1979 only about 75 Form 1042s the form which must be filed by a United States person making a payment to a foreign person were audited. ... The IRS simply is not in a position to audit tax haven holding or insurance companies claiming treaty benefits to determine whether they are eligible for those benefits ¶ p.165. Also, effective administration is likely to require assistance from the Treaty­Haven, since Conduits are likely to be set up under laws which allow companies to conceal their beneficial ownership, by using shares issued to bearer. Such assistance would obviously depend on whether the treaty partner government is willing, or even able under its own laws, to obtain information about beneficial ownership, and to supply it under the treatys exchange of information provisions, which may therefore require renegotiation US Treasury 1981, p.164, and Chapter 10 below. ii Treaty Benefits and Investment Flows Although it is possible for a source state to take unilateral action to restrict or deny treaty benefits, to be effective such measures should be specific and targeted in relation to each treaty­partner. They must take into account not only the tax laws of that country, but also its regulation of foreign exchange, banking and financial markets generally, and the pattern of investments between it and the source state. For these reasons, anti­conduit measures have become increasingly specific, and have been negotiated between treaty­partners, aiming at agreed provisions to combat abusive treaty shopping. A number of issues are involved in considering what constitutes `abuse ¶in this context. Reduced or low withholding taxes on payments to non­residents aim to encourage inward investment, and this desire conflicts with the objective of ensuring that such foreign investors bear a fair tax burden, or capital­ import equity US Treasury 1981, p.152. Thus, the US IRS as late as the mid­1970s was issuing administrative rulings permitting the use of Netherlands Antilles holding companies as conduits for investment into the United States, for example in real estate; as well as for the issuing of Eurobonds by financial intermediaries of TNCs. Between 1965 and 1973 some ten billion dollars worth of Eurobonds were issued by US TNCs through Netherlands Antilles intermediaries, with the encouragement of the US Treasury Langer 1978 p.741. However, the availability of low withholding taxes gave a considerable inducement to foreigners not resident in US treaty partner states, to take advantage of conduit arrangements to route their investment into the US. Thus, by 1978 about one­third of the approximately 22bn worth of stocks in US companies owned by non­residents were held in Switzerland, 90 of them by Swiss banks on a nominee basis Langer 1978 p. 742; US Treasury 1981, Table 1 p.177. The US suggested to its treaty partners a certification system with arrangements for the balance of the tax to be collected and refunded where the recipient was found to be a nominee. Although some, such as the Swiss authorities, were willing to try, the sheer volume of transactions created considerable administrative difficulties. 1 Other countries would not do so, often because their own laws made it impossible to trace owners of bearer shares or beneficiaries of nominee accounts. 2 This in effect meant that loan capital for an investment in the US was substantially cheaper if channelled through such a foreign conduit; not surprisingly this created a temptation for US residents to use the same means to evade US taxes Karzon 1983. Thus, international avoidance undermines tax legitimacy and stimulates more flagrant evasion.

3. Combating Treaty­Shopping