M&A Vocabulary: Understanding “Treaty Shopping”

“Treaty Shopping,” or “buying into” a double taxation agreement, refers to tax-motivated arrangements where a taxpayer uses an interposed company to exploit favorable Double Taxation Agreements (DTAs) and thereby obtain tax advantages.

Example: An investor “I” is resident in State A and intends to establish a company “K” in State B. However, State A and State B have not concluded a DTA. A DTA has been agreed between State A and State C, as well as between State B and State C. To utilize the DTA preferences, e.g., for withholding taxes on dividend distributions, I now establishes an intermediary company “Z” in State C, which becomes the parent company for K in State B. Dividends, interest, or royalties are now distributed from company K in State B via company Z in State C to I – utilizing the DTA privileges.

In the past, countries such as the Netherlands, Cyprus, and Luxembourg were popular states for such intermediary companies. A variation of Treaty Shopping is Directive Shopping, which exploits the tax advantages of EU directives (Parent-Subsidiary Directive, Interest and Royalties Directive).

In the example, I benefits from a DTA concluded by State B without being resident in the corresponding state (C). Since such arrangements are undesirable, many states have introduced so-called “Anti-Treaty Shopping” rules.

The OECD/G20 states have provided minimum standards for combating DTA abuse within the framework of the BEPS (“Base Erosion and Profit Shifting”) Action Plan in BEPS Action 6.

In Germany, Anti-Treaty Shopping rules have existed for over 25 years. According to these rules, it is examined whether a shareholder (in the example: I) of a foreign company (in the example: Z) could claim DTA preferences if they were directly involved. If – as in our example – this is not the case, the granting of DTA preferences is denied, unless the intermediary company meets certain substance requirements. Since the German regulation in its current version is contrary to European law, a new regulation is expected in the near future.

In Russia, Anti-Treaty Shopping rules were introduced in 2015 and tightened in 2017. According to Russian regulations, DTA preferences can only be applied if the recipient of the (dividend, interest, royalty) payment is also the beneficial owner. Since in our example Z forwards the dividends, interest, or royalties to I, Z is not the actual beneficial owner. To prove that a payment recipient is indeed the beneficial owner, the recipient must provide a confirmation from the paying company since 2017, demonstrating this proof. Only after presenting this proof and a certificate of residency may the paying company apply DTA preferences.

According to current court and administrative practice in Russia, to be recognized as a beneficial owner, a company must not merely forward the income received, but independently decide on its use, be actively involved in the market, and have personnel and premises. Pure holding companies are thus generally denied beneficial owner status. It should be noted that these regulations also cover cases where shares in a Russian company are held under corporate law by a German foreign holding GmbH, without any intention to abusively exploit DTA regulations. Since a tightening of Anti-Treaty Shopping rules is expected worldwide as part of the implementation of the BEPS Action Plan, corporate structures should be regularly reviewed in this regard.

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