Out-Law Legal Update | 18 Sep 2017 | 3:22 pm | 5 min. read
The Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the multilateral instrument or MLI) seeks to amend existing double tax treaties (DTTs) without requiring bilateral negotiations for every DTT. Broadly, the MLI covers hybrid mismatches, treaty abuse, permanent establishments and dispute resolution.
Using the example of a holding company in a European country (Country A) which receives interest from a UK subsidiary we consider what impact the MLI will have on the DTT between the UK and Country A. We assume the DTT is materially similar to the OECD Model DTT but provides for a 0% withholding tax rate on interest.
Domestic law and applying the DTT
The starting point is the position under UK domestic law. Section 874 of ITA 2007 provides the duty to deduct an amount equal to the basic rate of income tax from payments of yearly interest. Therefore, without more and absent a domestic exemption, a 20% withholding tax applies to the payment of interest by UKCo.
The application of the relevant DTT to this scenario initially appears straightforward. UKCo is resident in the UK and HoldCo is resident in Country A. As such, the payment of interest arising in one country to the other country is, in this case, taxed in that other country (Country A). Under
the DTT, the UK may not apply a withholding tax as long as HoldCo is the ‘beneficial owner’. HM Revenue & Customs (HMRC) applies the decision in a case involving a company called Indofood to interpret the term 'beneficial owner', as meaning having ‘the sole and unfettered right to use, enjoy or dispose of the asset in question’.
DTTs will be interpreted in light of their purpose and object, and HMRC considers that such purpose and object is not to allow for situations considered to be an abuse of a DTT. If in our example the holding company was located in Country A as a special purpose vehicle, passing that interest on via a back-to- back arrangement to its US parent chosen merely because that gave a better withholding tax result than if the UK subsidiary was paying the US parent directly, DTT relief would probably be denied on the basis of the Indofood decision.
Does the MLI apply to the double tax treaty?
The MLI applies to ‘covered agreements’, which are DTTs that each contracting party to the DTT has notified to the OECD. The list produced by the UK and Country A would need to be checked on the OECD website and, if there is a match, then the MLI applies once ratified by both countries.
The MLI itself comes into force three months after five countries have ratified it. Following this, it comes into force in respect of each country three months after its ratification. The MLI provisions will then come into effect from slightly later dates. For withholding purposes, it is from the beginning of the calendar year after the MLI comes into force for each of the relevant taxing jurisdictions. It will be necessary to check whether and when the UK and Country A have in fact ratified the MLI.
How does the MLI affect the relevant provision of the DTT?
In order to encourage countries to sign up to the MLI, there is a considerable amount of flexibility given to countries, allowing them to choose how and whether many of the provisions apply. Countries may make reservations in respect of certain provisions of the MLI so that they do not apply to that country’s covered agreements.
Some parts of the MLI require express notification by a country in order to apply to its DTTs. For example, the application of the simplified limitation of benefits (SLOB) provisions may be applied by notification pursuant to article 7(6) of the MLI. The UK does not intend to make such a notification and so the SLOB would not apply to the UK’s DTTs.
Even if an MLI provision seems to apply to the DTT in question, how it applies will depend upon the wording used. This is as follows:
Application of principal purpose test
The principal purpose test (PPT) contained within article 7(1) of the MLI disapplies a benefit under a DTT where obtaining that benefit is one of the principal purposes of the arrangements.
Article 7(2) of the MLI states that the PPT within article 7(1) shall apply ‘in place of or in the absence of’ provisions within a DTT. On the interpretation principles above, it would initially appear that the PPT would therefore apply, regardless of any notifications made by either party.
However, article 7 para 15(1) of the MLI provides some optionality. Here, there is the opportunity for a specific reservation where a relevant state intends to adopt alternative provisions (a detailed limitation of benefits rule and certain other rules to reach a minimum standard) or where there are already PPT provisions within the relevant DTT. If either party reserves for the former reason, then the PPT may not apply to that DTT.
Whether the PPT applies would therefore depend on the positions adopted by the relevant countries. The OECD has a handy tool on its website that highlights which provisions would or would not apply between countries. The UK intends to publish amended DTTs and this will help, but clearly the MLI has added an additional layer of complexity.
The UK has not exercised a reservation in respect of the PPT, so the PPT will now apply to all relevant treaties (other than where a detailed SLOB is negotiated on a bilateral basis).
An analysis would then need to be carried out as to the substance of the PPT and whether it disapplies treaty benefits in this case, so it would then be necessary to look at what reservations Country A has decided to apply to PPT. If it matches the UK’s position, the PPT overlays what is in the DTT and you wold then have to look at whether the PPT causes an issue in the particular case. If Country A is just a conduit, expect a problem here.
Jeremy Webster and Jamie Robson are corporate tax experts at Pinsent Masons, the law firm behind Out-Law.com. This update is an abbreviated version of an article which was published in Tax Journal on 1 September 2017.