BEPS Action 6 Report on Preventing the tax treaty benefits in inappropriate circumstances includes three alternative rules to address situations of treaty abuse. Firstly, a general anti-abuse rule (GAAR) is based on the principal purpose of transactions or arrangements. The second a simplified version of specific anti-abuse rules (SAAR), and the third a detailed version of specific anti-abuse rules. Specific anti-abuse provisions are known as limitation on benefits (LOB) provisions.
In today’s post, we will understand the Principal Purpose Test (PPT) mentioned under Article 17(1) of the Multilateral Instrument (MLI).
- Text of Article 7(1) of MLI
- Structure of Paragraph 1 of Article 7 of MLI
- Non-obstante Provision
- Reasonable Purpose Test Provision
- What is the ‘benefit’?
- Principal Purpose Test is examined qua transaction and each stream of income or capital.
- What is considered “reasonable to conclude”?
- Explain the meaning of “one of the principal purposes.”
- What is an “arrangement or transaction”?
- PPT extends to direct and indirect benefit under CTA
- Object and Purpose Test
- Evaluation of Principal Purpose Test
Text of Article 7(1) of MLI
“Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement 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 the Covered Tax Agreement.”
Structure of Paragraph 1 of Article 7 of MLI
Under Paragraph 1 of Article 7 of MLI, the Principal purpose test will operate notwithstanding any provision covered by the Covered Tax Agreement (CTA).
Dictionary meaning of ‘notwithstanding’ are:
- Not considering or being influenced by,
- Nevertheless, although, in spite of.
Article 7(1) introduces the mandatory nature of PPT by providing that benefit shall not be granted if PPT hits the arrangement or transaction.
Reasonable Purpose Test Provision
To understand the principal purpose test, understanding the keywords or phrases is critical. If we dissect the provisions, the following are the key phrases:
- a benefit under the Covered Tax Agreement 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.
What is the ‘benefit’?
The principal purpose test applies to every treaty benefit as the scope of the term ‘benefit’ is very wide. The test for determining the presence of treaty benefit is to ask what is the tax liability or tax incidence but for treaty intervention. Treaty benefit can exist every time tax liability is sought to be reduced by relying on one or the other provision of CTA. Suppose there is the likelihood of higher tax liability in the event of denial or absence of treaty. In that case, the tax benefit is said to exist for the analysis of the PPT Clause.
For instance, from the perspective of the source country, treaty benefit exists in relation to interest income if concessional withholding tax of 10% is applied under the CTA rather than the domestic tax rate of 20%.
Principal Purpose Test is examined qua transaction and each stream of income or capital.
The PPT is upon each transaction and stream of income or capital. It is not a qua entity as a whole. The income received in the treaty country may be eligible to claim the treaty benefit. However, he may have entered into some arrangement or transaction, which is considered tainted under PPT, and treaty benefits will be denied in relation to that arrangement or transaction.
What is considered “reasonable to conclude”?
Paragraph 1 of Article 7 of MLI states a “reasonable” opinion would suffice to deny treaty benefits if the arrangement or transaction fails PPT and no conclusive proof is needed. The low threshold for triggering PPT is criticized and the OECD Commentary 2017 clarifies that the alternative view needs objective examination, which mandates exercise of sound judgment, fairly, sensible and non-unreasonably.
OECD Commentary 2017 suggests that competent authorities should consider the possibility of different interpretations of the events objectively before concluding on the applicability of PPT limitation.
Explain the meaning of “one of the principal purposes.”
A transaction or an arrangement is considered tainted if one of the principal purposes is treaty benefit. Its principal purpose for the transaction or arrangement is considered treaty benefit if the motivation was to avail the benefits provided by the treaty and not motivated by business or commercial consideration.
As per OECD, where an arrangement is inextricably linked to the core commercial activity, and its form is not driven by consideration of obtaining treaty benefit, it is unlikely to trigger PPT.
Some of the commercial or business reasons to guide arrangements or transactions are as follow:
- concession in indirect tax
- ease of obtaining internationally recognized licenses
- ease of obtaining finance
- effective IPR, patents, trademarks,
- taking protection under a bilateral trade arrangement or investment protection agreement.
What is an “arrangement or transaction”?
PPT is applicable for the arrangements or transactions entered by the entity. Although MLI does not define the phrase. As per Article 29(9) of the OECD Commentary 2017, the term “arrangement or transaction” needs broad interpretation.
The term “arrangement or transaction” includes any
- transaction, or
- series of transactions,
- whether or not they are legally enforceable.
They include the creation, assignment, acquisition, or transaction of the income or property or right in respect of which income accrues.
The term “arrangement” is wider than the expression “transaction.” It also covers an understanding and may therefore encompass within its scope an event that need not necessarily involve two parties—steps taken by a company or an individual without the involvement of a counterparty.
PPT extends to direct and indirect benefit under CTA
PPT denies benefits under the Covered Tax Agreement in every case. It is reasonably possible to conclude that one of the principal purpose of an arrangement or transaction is to obtain a treaty benefit directly or indirectly.
OECD Commentary explains the significance of extending PPT to direct and indirect benefit :
- If an entity in favorable treaty jurisdiction is a party to a tax avoidant arrangement, it is the case of direct benefit.
- Formation or involvement of SPV in a favourable treaty jurisdiction is a case of indirect benefit.
Object and Purpose Test
The latter part of Paragraph 1 of Article 7 of MLI provides for a significant carve-out. Suppose one of the principal purposes of the arrangement or transaction is treaty benefit. In that case, the benefits of the treaty will not be denied so long as the grant of benefit follows the object and purpose of the relevant provisions of the CTA. The scope and circumstances under which the above-mentioned carve-out functions are not provided clearly and are not easy to determine.