Multilateral instrument for the of elimination of double taxation

published on 1 May 2017

Pursuant to the BEPS Action Plan (Base Erosion and Profit Shifting), specifically Action 15, the OECD proposed and subsequently released a multilateral instrument called the ”Multilateral Convention to implement tax treaty related measures to prevent base erosion and profit shifting” (the ”MLI”), which is aimed at implementing the main ideas behind the BEPS action at the level of individual treaties on elimination of double taxation (double taxation treaties). The multilateral platform was chosen primarily so that it would not be necessary to amend individual bilateral treaties signed by member states. Such a route would most certainly be very complicated and time consuming as it would require the renegotiation of approximately 2 thousand treaties on elimination of double taxation.

The MLI was not designed to replace the existing double taxation treaties, it was designed to be used in an auxiliary manner in addition to the relevant double taxation treaties. The aim is to modify the relevant provisions of existing treaties so as to bring them into compliance with policies designed to combat BEPS. With the exception of the mandatory minimum standard, which prevents the granting of treaty benefits in inappropriate circumstances (i.e. prevents abuse of double taxation treaties - BEPS 6) and contains provisions that make dispute resolution mechanisms more effective (BEPS 14), it is up to the discretion of individual states to choose which treaties and provisions they wish the MLI to be applicable to. In order for a specific MLI provision to be subsequently applicable to a particular double taxation treaty, the other contracting state that signed such double taxation treaty must have also chosen the applicability of such MLI provision.

The core parts of the MLI deal with the following:

Neutralizing the effects of hybrid mismatches (BEPS 2)
Preventing the granting of the benefits of double taxation treaties under inappropriate circumstances, i.e. treaty abuse (BEPS 6)
Preventing the artificial avoidance of permanent establishment status (BEPS 7)
Making dispute resolution mechanisms for international tax disputes more effective (BEPS 14)

1. Hybrid mismatches

A hybrid mismatch is an arrangement of tax relations between taxpayers (typically the cross-border arrangements implemented by multinational enterprises) that leads, as a result of differences in the tax treatment applied by different jurisdictions, to excessive tax advantages in the form of double non-taxation of income or long term deferral of tax obligations. The different tax treatment can be applied both to a taxable entity itself (a so-called hybrid entity, one that is considered to be transparent from a tax point of view in one jurisdiction but is not transparent from a tax point of view in the other jurisdiction) and to financial instruments and transactions between taxable entities. A hybrid mismatch can also arise as a result of dual tax residence.

Example – a hybrid mismatch in the case of a financial instrument

A parent company that is a resident of state A provides a loan at an arm's length interest rate to its subsidiary that is a resident of state B. State B treats the interest paid to the parent company as a financial expense, one that reduces the tax base of the subsidiary. However, state A treats such financial instrument as an ownership stake which generated a dividend, and under the rules of State A such dividend is exempted from tax. As a result of the differences in the tax treatment of the relevant financial instrument, a hybrid mismatch arises (this type of mismatch is called Deduction / No inclusion). The tax-deductible expense in one jurisdiction was not compensated by a corresponding tax on taxable income in the other jurisdiction.

In the area of hybrid mismatches, the MLI focuses primarily on transparent entities and on preventing the inappropriate drawing of tax benefits under double taxation treaties by entities that have dual residence.

2. Preventing the abuse of double taxation treaties

The MLI adds to the preamble of existing double taxation treaties a clear declaration that the intent of such treaties is to prevent double taxation, without creating opportunities for avoiding taxation altogether or opportunities for reduced taxation through tax evasion, tax avoidance or treaty shopping. Treaty shopping is the expedient drawing of benefits under double taxation treaties by a resident of a third jurisdiction.

Example – Treaty shopping

A company that is a tax resident of state A receives income the source of which is in state B. State A does not have a double taxation treaty with state B. However, there is a double taxation treaty between state B and state C. So if the aforementioned company structures its business transactions through state C in order to obtain the benefits available under the double taxation treaty between states C and B, this is called treaty shopping. The MLI considers such conduct to be undesirable and in such situations the relevant MLI provisions would deny such company the benefits available under the double taxation treaty between states C and B.

Prevention of abuse of transactions (Principal purpose test)

In addition to the above-described provisions to be added to the preambles of double taxation treaties, the MLI also contains a specific provision designed to prevent entities from using transactions the main purpose of which is to enable such entities to expediently obtain the benefits available under individual double taxation treaties (the so-called Principal purpose test). This rule forms part of the mandatory minimum standard for BEPS and parties to double taxation treaties cannot decide not to implement it, unless the relevant treaty already contains its own set of rules or tests that determine whether a particular entity is eligible for the benefits available under such double taxation treaty (for example, Article 17 – Limitation of benefits in the double taxation treaty between the Czech Republic and the United States).

Withholding tax on dividends

The MLI also provides for the possibility of stipulating a minimum time period for eligibility for a lower rate of withholding tax on dividends.

Example – Reduced withholding tax on dividends

The current wording of the treaty between the Czech Republic and Slovakia makes it possible to apply a lower withholding tax on dividends, specifically 5 percent of the gross dividend, if the actual owner is a company that directly owns at least 10 percent of the capital of the dividend paying company. Under the MLI, this benefit could only be provided if a 365 day time period requirement has been met.

The MLI also contains a voluntary provision that expands the ability of a state to tax income from the sale of an ownership stake in a company whose capital is primarily made up of real estate. For example, the treaty between the Czech Republic and the United States also contains a provision which treats as real estate any ownership stake in a company whose capital derives more than 50% of its value from real estate located in the other contracting state. The MLI expands the ability to tax such assets if this condition is met at any time in the course of a time period of 365 days.

3. Artificial avoidance of permanent establishment status

In order to combat efforts to artificially avoid permanent establishment status, the MLI contains new rules that significantly expand the definition of a permanent establishment in the other contracting state. Since these rules are not part of the minimum standard for implementation of the MLI, it is up to individual states to decide whether they wish to implement such rules.

Dependent agent

Firstly, the MLI reduces the ability of companies to avoid the status of a permanent establishment by doing business through an agent that is presented as an independent agent but is in fact a dependent agent acting for the relevant company. Most existing double taxation treaties define a dependent agent as an individual or entity that possesses authorization from the relevant company to conclude contracts in such company's name. The MLI makes this definition broader, meaning that in order for an agent to be classified as a dependent agent (which means that a permanent establishment is deemed to exist), it is sufficient if such individual or entity merely plays a key role in the conclusion of such contracts.

Independent agent

In contrast with a dependent agent, an independent agent qualifies for an exemption from permanent establishment status, meaning that if a company conducts business in the other contracting state through an independent agent, the company is not deemed to have a permanent establishment in such other state. The MLI makes the definition of an independent agent stricter. Under the MLI, an individual or entity that acts exclusively or almost exclusively on behalf of one or more companies with which such individual or entity is closely linked cannot be regarded as an independent agent (and consequently a permanent establishment is deemed to exist).

Auxiliary or preparatory activities

Presently the text of most double taxation treaties contains an exemption from permanent establishment status that applies to situations where an enterprise based in one of the contracting states performs certain specified activities, i.e. activities that the treaty exempts from permanent establishment status. This typically involves facilities that serve for maintaining warehouse stock in order to store it or to deliver it or to have it processed by another enterprise and so forth. Another exemption applies to any activity that is of an auxiliary or preparatory nature (for example, performing a market survey of the local market).

The MLI provides for the possibility of adding the additional requirement of ”auxiliary or preparatory nature” to all of the aforementioned activities. So in order for an enterprise to avoid the status of a permanent establishment when storing goods in the other state, it would be necessary to additionally fulfill the requirement that the relevant activities must be of an ”auxiliary or preparatory nature”.

Example – Auxiliary or preparatory activities

A company whose main business object consists of mail order sales has a large warehouse in another contracting state from which it ships goods to various countries throughout the world. Under the new MLI rules, this company would be deemed to have a permanent establishment because it would be very difficult to argue that the relevant activities were of an "auxiliary or preparatory nature".

Splitting-up of contracts

The MLI also contains a draft measure designed to prevent companies from artificially avoiding permanent establishment status by splitting up the duration of contracts into several shorter periods. After such splitting, each individual contract is shorter than the time period that gives rise to permanent establishment status in the other contracting state. The MLI aggregates the durations of such contracts so as to treat them as a single contract. The MLI also has provisions that prevent companies from circumventing the foregoing time period by splitting an order between several related companies.

4. Making mechanisms for the resolution of international tax disputes more effective

Since the application of BEPS policy is very likely to bring about more tax disputes relating to the application of double taxation treaties, the MLI contains a binding clause aimed at streamlining those provisions of a treaty that address the resolution of disputes via mutual agreement between states. The mechanism for the resolution of complaints filed by taxpayers pursuant to a double taxation treaty should also be improved under the MLI.

Conclusion

The multilateral convention should be signed at a gala ceremony in June 2017 in Paris. This is expected to be followed by ratification at the level of individual member states. We will keep you informed about the extent to which the convention will be implemented in the Czech Republic and the impact it will have on domestic taxpayers.