Treaty Shopping The Abuse of Tax Treatie

Treaty Shopping – The Abuse of Tax
Treaties

Syed Akbar Hussain

Samantha Rebecca King

CONTENTS
CONTENTS .................................................................................................................................... 2
ABBREVIATIONS ........................................................................................................................ 3
INTRODUCTION .......................................................................................................................... 4
TAX TREATIES ............................................................................................................................ 6
Treaty Shopping in Practice ........................................................................................................ 7
Case Study – Sir Philip Green .................................................................................................... 8
ACTION PLAN ON BASE EROSION AND PROFIT SHARING (BEPS) ........................... 10
Limitation-of-Benefits Rule ...................................................................................................... 13
General Anti-Abuse Rule .......................................................................................................... 14
Response by Parties to the Draft Proposal .................................................................................... 15
PRACTICAL APPLICATIONS OF ANTI-ABUSE RULES ...................................................... 16
CONCLUSION ............................................................................................................................. 18
Bibliography ................................................................................................................................. 19


ABBREVIATIONS

OECD - Organisation for Economic Co-operation and Development.
DTA – Double Taxation Agreement
BEPS - Action Plan on Base Erosion and Profit Sharing
WHT – Withholding Tax
FA – Finance Act [2008]

ITTOIA - Income Tax (Trading and Other Income) Act [2005]
LOB – Limitation-On-Benefits Rule
GAAR – General Anti-Avoidance Rule
BBA – British Banker’s Association
AFME - Association of Financial Markets in Europe

INTRODUCTION

This essay will explore the Abuse of Tax Treaties by the means commonly known as Treaty
Shopping. Treaty Shopping has been defined by carious entities and scholars in various forms. We
will first present what its definition happens to be and then continue with explaining the scope of

this essay.
We first have the definition provided by the Business Insider:

The practice of structuring a multinational business to take advantage of more
favorable tax treaties available in certain jurisdictions. A business that resides in
a home country that doesn't have a tax treaty with the source country from which
it receives income can establish an operation in a second source country that does
have a favorable tax treaty in order to minimize its tax liability with the home
country. Most countries have established anti-treaty shopping laws to circumvent
the practice.1

This is a fairly accurate description of the practice itself. Where a corporation wants to reduce its
tax amount, it seeks out ways to circumvent the existing methods. One way and it is amongst the
most debated circumvention techniques is the use of tax treaties and their benefits to reduce or
possibly eliminate certain class of taxes, mostly withholding tax from a country in which the
corporation is doing business.
Another definition is provided by BMR Advisors in an article as:
The term “abuse” or “misuse” of a tax treaty is not defined in the Model Tax Convention
(OECD or UN); Paragraph 9 of the commentary on Article 1 (OECD Model Convention
2008 update), however, provides guiding principles to determine cases of treaty abuse.

Two elements must be present for constituting abuse of tax treaty provisions –

1

(Treaty Shopping) http://www.businessdictionary.com/definition/treaty-shopping.html

1)

that the main purpose of entering into the transaction was to secure a more favorable

tax position; and,
2)

obtaining that more favorable treatment in given facts would be contrary to the

object and purpose of the relevant provisions of the tax treaty.2

This definition paints a different picture as it seeks to paint treaty abuse as a manner in which the
purpose for which the treaty was set up has been ignored and advantage has been taken without
paying heed to the possible illegality of the transaction, particularly in light of the objects of the

treaty.

In this essay, we will briefly touch upon why Tax treaties or Double Taxation Agreements (DTA)
exist in the first place. Then we will touch upon the manner in which corporations and accountants
have manipulated them to formulate a result of tax minimization that was never intended and a
Case Study. Finally, we will dive into the crux of the essay which is the future working of the
Organisation for Economic Co-operation and Development (OECD) analysis of the Action
Plan on Base Erosion and Profit Sharing (BEPS) and the draft proposal suggested to combat
the increasing threat of treaty shopping which has reduce the taxation base for many countries who
have been exploited for their resources or who have created value for the companies.
We will then conclude after having explored the development and possible future of the tax treaties
and the OECD’s role in trying to keep them alive and be of benefit to the countries that sign it.

2

(Tax Treaty Abuse' And 'Anti-Avoidance Rules')

TAX TREATIES

On of key objective for double taxation agreements (DTAs) or Tax Treaties is the promotion of

international trade. Double Taxation is a concept that requires a definition, which is provided by
Investopedia as:
A taxation principle referring to income taxes that are paid twice on the same source of
earned income.3

In international law, double taxation occurs when an entity may be considered taxable in two
separate jurisdictions, by virtue of having a Permanent Establishment in the foreign country as
defined by Article 5 of OECD Model Tax Convention.
For the purposes of this Convention, the term “permanent establishment” means a fixed
place of business through which the business of an enterprise is wholly or partly carried
on.4

This would allow the entity to be taxable in two states for the same source of income. This would
cause considerable loss to the taxpayer, hence DTAs are negotiated to eliminate the problem of
double taxation and encourage international trade.
However, their use became subject to scrutiny by various states as multiples corporations began
engaging in treaty shopping and abused the tax treaties.

3


(Investopedia) http://www.investopedia.com/terms/d/double_taxation.asp
(Model Tax Convention on Income and Capital) http://www.oecd.org/ctp/treaties/2014-model-tax-conventionarticles.pdf
4

Treaty Shopping in Practice

An example of such abuse is when a company in a low tax jurisdiction plans to invest funds as a
loan in the UK. The UK does not have a DTA with the country and therefore interest paid directly
to the haven company would ordinarily be subject to deduction of UK tax at source. To avoid this
withholding tax, the company channels the funds through a company set up for this purpose in,
say, Luxembourg. The Luxembourg company receives interest from the UK which it then pays on
to the true source country. UK withholding tax on the interest is reduced to nil under the terms of
the UK/Luxembourg DTA. Luxembourg does not levy withholding tax on interest paid on to the
haven country (except where the EU Savings Directive applies) under its domestic law. If there
were no provisions to counteract the effect of the arrangement, the tax haven company would
therefore benefit from the UK/Luxembourg DTA, though the income is subject to tax in
Luxembourg only to an insignificant degree (on the marginal turn taken by the Luxembourg
company) and not subject to tax at all in the UK.

Such arrangements could also be used where the beneficial owner is resident in a territory where

the DTA retains a residual rate of WHT even after a clearance or claim for repayment of tax
withheld. Australia or Canada, for example, where the territory of source (and obviously that can
mean the UK as treaty partner in each case) retains 10% even after clearance.

Thereby, a corporation could structure itself in various countries in such a way so as to evade
having to pay tax at the country where the revenue is generated, causing a loss to that country on
potential tax revenue. This is offset by the DTA which grants certain benefits to the two countries
so the country facing the loss would be saved by the DTA. Yet, when the country through which
tax is evaded itself is not receiving the income either and therefore, is not able to tax it, then the
entire transaction is a loss for both countries as they have both been used to reduce the tax liability
of a corporation5.

5

(IFS Consultants) http://www.interfis.com/articles/treaty-shopping

Thus, the proposed rules for preventing the granting of tax treaty benefits may adversely affect
taxpayers who are seeking treaty benefits for their genuine commercial and investment
transactions. It will be essential that any proposals aimed at preventing abuse provide taxpayers
with clarity and certainty on how treaty benefits will be accessed. The negative effects that tax

uncertainty has on cross-border trade should not be underestimated.

Case Study – Sir Philip Green

A prime example of where Treaty shopping is proving damaging to a countries economy is in the
United Kingdom (UK). In fact, one of the country’s biggest tax evaders, Sir Philip Green, who
possesses around 12% of the UK’s retail market, dodges around £1.2 Billion each year in taxes.
Green, in spite of being a working resident in the UK, has registered his company (the Arcadia
Group) in his wife’s name, a resident in Monaco, and thus, as a beneficial owner, enjoys a 0%
income tax rate since the Inland Revenue cannot tax any dividends paid from the corporation. This
costs the British taxpayers £285 Million, enough to pay 9,000 NHS nurse salaries6 and as a result
has made Mr Green one of the most well-known figures for tax avoidance in the UK7.

Although this may appear illegal, Green is one of thousands of business owners who each year
concealing millions of pounds worth of assets through treaty shopping. It is through Section 5759 of the Finance Act [2008]8 (FA) that companies operating in the UK are able to avoid state tax.
Although Section 58, FA 2008 attempts to use a sledgehammer approach to tighten up another
aspect of the double tax relief anti-avoidance rule, it was the highly publicized case of Padmore
v IRC9 which demonstrated why this particular approach is less than effective. The Court of
Appeal found that the taxpayer was exempt from tax on his foreign income from a Jersey-based
partnership. This was because the UK-Jersey double tax treaty exempted a Jersey resident


6

(The Huffington Post) http://www.huffingtonpost.co.uk/2013/11/05/russell-brand-philip-green_n_4217377.html
(Which is bigger: the bill for benefit fraud or tax evasion?) http://www.theweek.co.uk/uk-news/62461/which-isbigger-the-bill-for-benefit-fraud-or-tax-evasion
8
(Finance Act [2008], 2008) http://www.legislation.gov.uk/ukpga/2008/9/pdfs/ukpga_20080009_en.pdf
9
(Padmore v Inland Revenue Commissioners, [1989] STC 493)
7

enterprise from UK tax, except for business carried on through a permanent establishment in the
United Kingdom. In the context of the treaty, ''enterprise'' was held to include a partnership, which
was consequently exempt from UK tax. Even before the case was decided, the Government had
changed the law (now in Section 858 of the Income Tax (Trading and Other Income) Act
[2005]10 (ITTOIA 2005)) to make clear that, whatever the double tax treaty might say, a UKresident partner's income from a foreign partnership was subject to UK tax. Controversially, this
provision was made retrospective; accepting only appeals in process at the time the change was
announced.
Schemes have now come to HMRC's attention that attempt to circumvent Section 858 ITTOIA
[2005] by using a trust structure. The partners in the foreign partnership are trustees of trusts of

which UK taxpayers are the beneficiaries. Thus, it is claimed that Section 858 ITTOIA [2005],
which refers to the partners only, should not apply to the beneficiaries of the trust, hence why Sir
Philip Green and his wife are not in breach of the current law for only paying a small percentage
of their annual gross towards tax, since following him registering the company in his wife’s name,
he is nothing more than a beneficial owner.
As a result, section 58 FA [2008] is often criticized for its retrospective effect. Section 59 FA
[2008], however, is not retrospective. It intends to ensure that other schemes, not using
partnerships, cannot succeed in exploiting the language of double tax treaties to exempt UK
residents from UK tax. In spite of the attempted efforts in the prevention of tax-avoidance from
this statute, it is evident how companies whom rely on the ‘beneficial owners of the trust’ loophole
continuously and successfully avoid tax each year without any legal consequences.

10

(Income Tax (Trading and Other Income) Act [2005])
http://www.legislation.gov.uk/ukpga/2005/5/pdfs/ukpga_20050005_en.pdf

ACTION PLAN ON BASE EROSION AND PROFIT SHARING (BEPS)

Thereby, with the situation of global economics and politics fretting over the solution the OECD

called for a change to the existing Conventions and there methodology of trying to prevent treaty
shopping via the Beneficial Ownership approach laid down in the OECD Model Tax Convention
which seeks to allow the benefit of the treaty only to the beneficial owner.11
In 2013, the Organization for Economic Co-operation and Development (OECD) and G-20 came
together to, among other matters on the agenda, discuss the problem and possible solution to the
abuse of tax treaties. This culminated in the Action Plan on Base Erosion and Profit Shifting
(BEPS)12. This plan in its introduction wishes to make possible that profits are taxed where the
economic activities generating the profits are performed and where the value is created13. This
resulted in the report titled, Preventing the Granting of Treaty Benefits in Inappropriate
Circumstances14 as part of Action 6.
This report suggests amendments to the OECD Model Tax Convention. This Convention used as
a Model by various countries to create a tax treaty that was initially envisaged to prevent double
taxation has now become source of problems caused by abuse of the same treaties to evade
corporate taxation. Thereby, the changes suggested by the report intend to prevent this treaty abuse.
Although, this is a draft proposal, it provides insight into how the OECD wishes to proceed with
this problem, nevertheless the final report is expected to be different yet only in certain details.
The matters put forth in this paper will provide useful information on the aims and methods to be
adopted.
First we will see what Action 6 of the BEPS requires:

11

(IFS Consultants)
(Action Plan on Base Erosion and Proit Sharing)
13
(OECD’s Draft Proposal on Treaty Shopping, Treaty Abuse Situations, 2015)
14
(Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, 2014)
12

Treaty Abuse
Develop model treaty provisions and recommendations regarding
the design of domestic rules to prevent the granting of treaty benefits
in inappropriate circumstances. Work will also be done to clarify
that tax treaties are not intended to be used to generate double nontaxation and to identify the tax policy considerations that, in
general, countries should consider before deciding to enter into a
tax treaty with another country. The work will be co-ordinated with
the work on hybrids. 15
Further on, it requires a redefinition of the Permanent Establishment, specifically to prevent
abuses. It mentions that a lot of corporations use subsidiaries in various countries to minimize their
liability by not being a distributor and therefore not being taxable to the same extent. The corporate
structure is maneuvered in such a way as to reduce their taxation requirement and channel profits
and funds in such a way by the use of various tax treaties and treaty shopping so as to be able to
legally not be required to pay tax in various jurisdictions where they may operate and thus take
advantage of the treaties themselves and harm the economy of the state from whom they managed
to bypass the taxation grounds.16

15
16

(Action Plan on Base Erosion and Proit Sharing, p. 21)
(Action Plan on Base Erosion and Proit Sharing, p. 21)

Preventing the Granting of Treaty Benefits in Inappropriate
Circumstances
This report wishes to address the following areas of Action 6:
A.

Develop model treaty provisions and recommendations regarding the design of
domestic rules to prevent the granting of treaty benefits in inappropriate
circumstances.

B.

Clarify that tax treaties are not intended to be used to generate double non-taxation.

C.

Identify the tax policy considerations that, in general, countries should consider
before deciding to enter into a tax treaty with another country.17

These areas are further on continued in detail as Section A, B & C of the report which broadly
translate to the following aims which we shall explore in depth below as well:
1. It should be provided in the Title and the Preamble of a tax treaty that purpose of the tax
treaty is not intended to generate double non-taxation.
2. Establishing a specific anti-abuse rule called a Limitation-of-Benefits (LOB) rule in the
treaty.
3. Incorporate a general anti-abuse rule aimed at preventing the use of the tax treaty if the
relevant transaction has the prime purpose of obtaining the benefit of the tax treaty. This is
exempted if it can be shown that applying the treaty would be in accordance with the
objects of the treaty.
Now we will proceed with expanding the relevant provisions to see how the Model Treaty will
change and what provisions will be used to thwart the abuse of the treaties.

17

(Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, 2014, p. 18)

Limitation-of-Benefits Rule

The specific LOB rule is laid down in Article 16 of the report18 and is adapted from various similar
provisions in tax treaties by the United States, Japan and India. The rule lays down a number of
objectives and criteria that must be satisfied for the treaty to apply to a transaction. The following
is the first para of the amended Article 10 of the Model Treaty.
ARTICLE X
ENTITLEMENT TO BENEFITS
1.

Except as otherwise provided in this Article, a resident of a Contracting

State shall not be entitled to a benefit that would otherwise be accorded by this
Convention (other than a benefit under paragraph 3 of Article 4, paragraph 2
of Article 9 or Article 25), unless such resident is a “qualified person”, as
defined in paragraph 2, at the time that the benefit would be accorded.19

This rule brings about the requirement of the “qualified person” to be satisfied. In subsequent
paras the report goes on to specify who or what a qualified person is. Thereby the treaty limits the
benefits derived from it by virtue of this clause and the requisite requirement of each state to define
their version of “qualified person”. Thus, this rule will address a large number of treaty-shopping
situations based on the legal nature of, ownership in, and general activities of taxpayers intending
to take advantage of the tax treaty.20

18

(Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, 2014, p. 24)
Ibid
20
(OECD’s Draft Proposal on Treaty Shopping, Treaty Abuse Situations, 2015)
19

General Anti-Abuse Rule

In pre-emption of a possible loophole found in the LOB rule, the report suggests a second
overarching rule for judicial discretion to be able to use to prevent the abuse of the treaties,
specifically to include and prevent treaty shopping situations that are not covered by the specific
LOB rule. This rule is framed in Article 17 of the report as follows:
As previously indicated, the following rule, which incorporates principles already
recognised in the Commentary on Article 1 of the OECD Model Tax Convention, provides
a more general way to address treaty avoidance cases, including treaty-shopping
situations that are not covered by the specific anti-abuse rule in subsection A.1(a)(i) above
(such as certain conduit financing arrangements):
ARTICLE X
ENTITLEMENT TO BENEFITS
7.

Notwithstanding the other provisions of this Convention, a benefit under this

Convention shall not be granted in respect of an item of income or capital if it is
reasonable to conclude, having regard to all relevant facts and circumstances, that
obtaining that benefit was one of the principal purposes of any arrangement or
transaction that resulted directly or indirectly in that benefit, unless it is established that
granting that benefit in these circumstances would be in accordance with the object and
purpose of the relevant provisions of this Convention.21

This rule goes in line with the objectives of the OECD’s commentary22 on Article 1 (Persons
Covered) of the Model Tax Convention. Where an arrangement or transaction has its main
purposes as the benefit of the tax treaty then it is not in line with the aims of the treaty and the
benefits of the treaty shall not be available to it.

21
22

(Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, 2014, p. 66)
(Commentary on the Articles of the Model Tax Convention, p. 3)

Response by Parties to the Draft Proposal
In a letter written by the BBA (British Banker’s Association) and AFME (Association of Financial
Markets in Europe) on 9th April 2014, the institutions collectively offered their opinion about the
draft under discussion as per the Action 6 of the BEPS23.
In the letter, they express concern on behalf of the banking sector that the treaty, “taken as a whole,
the proposals represent a disproportionate response to any potential abuse of the tax treaty
system24” and that the measures will create uncertainty as to whether the treaty is available in
ordinary commercial transactions and pull apart the effort that has been put in over the past decades
to use the treaties to facilitate international trade.
They assert that the key element of DTA (Double Taxation Agreements) is to facilitate and
enhance international trade and the current proposal affect people trying to immerse in genuine
commercial transactions and any proposal aimed at improvement should provide clarity and
certainty to taxpayers on how to benefit from the treaty.

They recommend that OECD work with existing tools that have precedence and sound business
practices geared towards them. The use of LOBs and General Anti-Avoidance Rules (GAAR)
requires a lot of new analysis and knowledge as their use is not very frequented and would require
a great deal of understanding. It is their position that the existing use of beneficial ownership and
permanent establishment concepts have already undergone extensive scrutiny and with relative
little amendments can be incorporated into the Model Tax Treaty, thereby making the need for
new law and rules redundant. Especially, if the alternate is uncertainty about the treaties and the
legality of certain transactions which rightful taxpayers will feel at their own expense for the sake
of minimizing the few bad apples who wish to abuse the tax treaties.

23
24

(Joint response to BEPS tax treaty abuse paper, 2014)
(Joint response to BEPS tax treaty abuse paper, 2014, p. 2)

PRACTICAL APPLICATIONS OF ANTI-ABUSE RULES
Interaction of Anti-Abuse and LOB Rules
There is a hierarchy of sorts in the application of the LOB Rules and the GAAR25.
“The general anti-abuse rule would seek to deny the tax treaty benefit even if the
primary objective criteria or the LOB rule is satisfied. That a company is a
"qualified person" (e.g., its shares are traded on a recognized stock exchange in
the country of residence) under the primary objective criteria does not mean,
however, that benefits could not be denied under Paragraph 7 for reasons that are
unrelated to the ownership of the shares of that company.”26

The Article by Sushant Mehta27 gives a possible example of how the GAAR could be applied.
“If a public company is a bank that is otherwise qualified to benefit from the tax treaty, it
may enter into a conduit financing arrangement and attempt to access the benefit under
the tax treaty from the source country. The general anti-abuse rule could be applied, and
the benefit of the tax treaty could be denied to the bank if it is established that the
principal purpose of the transaction or the arrangement that the bank had entered into
was with the intent to avoid taxes in the source state.
Example: A Corp. is a resident of country P. A Corp. owns C Corp., a wholly owned
subsidiary in country R. A Corp. intends to fund C Corp. through an intercorporate loan.
However, under the tax treaty between countries P and R, R will levy a withholding tax
on the interest C Corp. pays to A Corp. under the intercorporate loan.
But the tax treaty that country R has executed with country Q exempts the withholding tax
when a resident of country R raises external debt from a bank based in Country Q.
Accordingly, A Corp. places a deposit with a bank in country Q (Bank B), and the bank
subsequently finances C Corp. with a similar amount and keeps a minimal spread on the
interest. Without the deposit placed by A Corp., Bank B would not have lent to C Corp.
on the same terms and conditions as it did. Accordingly, in such a scenario, the general

25

(The Applicability and Effect of Tax Treaties Worldwide, 2014)
(OECD’s Draft Proposal on Treaty Shopping, Treaty Abuse Situations, 2015)
27
Ibid
26

anti-abuse rule under Paragraph 7 may apply to deny the benefit of a lower or a zero
withholding tax rate provided in the tax treaty between country Q and country R on the
interest payments C Corp. makes to Bank B, regardless of the fact that Bank B will be
able to meet the LOB rule in the tax treaty. As a consequence, the source country R may
disregard the tax treaty and apply the withholding tax under the domestic tax law to the
interest payment C Corp. makes to Bank B.”

The above example gives a very plausible hypothesis of how a General Anti-Avoidance Rule can
be expanded beyond any existing rules to encompass a transaction that may actually not be
illegal but will still not have the treaty applied to it because of the required objective of the
transaction, which cannot be purely to take advantage of the treaty.
Furthermore, it is clear that the LOB rule once laid down may be relatively clear and applicable
for taxpayers. The GAAR, however, demands new insight into how each country uses the
clauses inherent in their treaties and puts a greater deal of responsibility on them to ensure that
the rule is applied correctly and does not hinder the actual functioning of legal commercial
transactions. To do so, each country, as per the Draft proposal28 should perform an evaluation to
ascertain whether they have the necessary administrative infrastructure to cope with the
additional work and requirements of the treaty. This requires training the Human Resources as
well as adapting technology to expedite the process. Failing to do so will result in the very
uncertainty and problems that have been under concern and may lead to unpredictable dispute
resolution cases which will be time-consuming and costly.
Thus, there must be a concrete notion by the states on how to adopt and use the General AntiAvoidance Rule and not allow it to undermine the inherent functionality of the rule or its intent
by bogging it down with uncertainty and thus a possible withdrawal of treaty rights and clauses.

28

(Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, 2014)

CONCLUSION

When questioned by the Australian Senate Public Committee about their practice of treaty
shopping to abuse tax treaties and circumvent their responsibility to pay tax, Google’s Maile
Carnegie, managing director of Google in Australia and New Zealand, said:
“When I think about morality I don’t think about it in terms of geographic boundaries …
we are not opposed to paying tax but we are opposed to being uncompetitive … when I
think about the morality, the people who need to answer … are the people sitting on your
side of the room,” she told the senators.
“I am not saying whether those arrangements are right or wrong … they are simply the
way the global tax system is working.”29

On that same panel were Microsoft and Apple who were being required to defend their tax
manipulation by funneling their revenue through Singapore and depriving Australia of the tax
earned on its soil.

Treaty shopping is a mechanism created after DTAs came to allow a means to do so. The OECD
and many other jurisdictions will continue to find ways to combat it yet, as put forward by the
BBA, there must be a balance and whether that has been achieved through the use of the LOBs
and GAAR is yet to be seen. Nevertheless it is not within doubt that corporations who want to
save money and evade taxes will find sufficient means to legally do so.

29

(Taylor, 2015) http://www.theguardian.com/australia-news/2015/apr/08/google-apple-and-microsoft-defend-taxset-up-that-shifts-revenue-offshore

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